Strong US inflation is driving market expectations of a 5% or higher fed funds rate in a matter of months

With inflation showing no signs of abating, expectations are building in financial markets for a 5% fed funds rate by March, likely leading to more volatility in stocks, bonds and currencies.

Barclays expects the US benchmark interest rate target to reach between 5% and 5.25% in February, from a current level between 3% and 3.25%, due to increases of “more aggressive and anticipated” rates from the Federal Reserve, according to a note published on Thursday. In the meantime, fed funds futures traders sees a 38.8% chance that rates reach at least that level by next March, up from 6.1% on Wednesday, according to the CME FedWatch tool.

Watch: Fed benchmark interest rate may top 5% after September inflation data, some economists think

The game changer Thursday was hotter than expected. consumer’s price index September report, which reflected worrying jumps in headline readings excluding food and energy and produced the seventh consecutive annual headline reading of more than 8%. Until now, many in the financial markets have had trouble adjusting to the likelihood that only one approximately 4% fed funds rate for November, which would be the highest level in more than a decade. Now, traders and economists point to the likelihood of further volatility as expectations grow around a 5% fed funds rate, a level last seen in 2006, with investors ready to dump stocks and bonds. and favor the dollar.

A 5% fed funds rate would be “negative for stocks and earnings and lead to more bond sell-offs,” said Tom di Galoma, managing director of rate trading at Seaport Global Holdings in Greenwich, Conn. “It would also be absolutely devastating for the economy. The loan market would be completely closed at that point, and banks would not be approving home loans or business loans.”

“People are completely taken aback by rates that have moved as much as they have in the last three months. I certainly didn’t expect a 2-year 5% rate, but it looks like that’s where we’re headed,” di Galoma said by phone. “We are not going to see a superficial recession, but something more massive than what people are used to. We are going back to at least the global financial crisis here because all the places in the world are slowing down” and all these markets are in the process of “breaking down”.

Rex nut: Everyone is looking at the CPI through the wrong lens. The best measure shows that inflation fell to the Fed’s target in the past three months.

On Thursday, investors reacted to the September CPI report by initially lowering the three major US stock indices.
DJIA,
+2.83%

SPX,
+2.60%

before them bounced back sharply to finish higher. Analysts said shares were due to rise after a six-day sell-off that left the S&P 500 on Wednesday at its lowest close since November 2020.

The policy-sensitive 2-year Treasury rate
TMUBMUSD02Y,
4,460%

soared to nearly 4.5%, a new 15-year high, while the 30-year yield
TMUBMUSD30Y,
3.908%

reached 3.93% or its highest level since January 3, 2014.

In response to Thursday’s CPI report, Treasury Secretary Janet Yellen had expressed concern about the potential for problems related to weak trading conditions in the US government debt market, according to news reports. She was quoted as saying after a speech on Wednesday that “we are concerned about an adequate loss of liquidity in the market.”

A potential illiquidity in the $23.7 trillion Treasury bond market is just one of many cracks that appear to be forming in financial markets as central bankers raise interest rates at the fastest pace in decades. , which triggers a debate about whether the next financial crisis it is unavoidable.

Talk about a 5% fed funds rate has been around for at least the last month, but has always seemed to get buried behind a more general dialogue about what the Fed might do in November.

The reason the CPI report moved the needle is because “hopes that lower inflation would come from a resolution of supply chain adjustments have faded, and the supply chain improvements that have been transferred to consumers are still not enough,” he said. Will Compernolle, a senior economist at FHN Financial based in New York. “The era of globalization that pushes down the prices of goods may be over.”

He said the FHN chief economist expects a 6% federal funds rate at some point, which will exacerbate global recession headwinds and keep the dollar strong. The first thing that could collapse in the global economy “is Europe, as it enters a severe recession,” Compernolle said by telephone on Thursday.

For Ben Emons, managing director of global macro strategy at Medley Global Advisors in New York, “there is no doubt that US inflation is getting out of control.”

Equity markets have yet to assess the likelihood of a 5% fed funds rate for the first half of 2023, Emons wrote in an email Thursday. The immediate consequence of the latest inflation update confirming that inflation is averaging 8% year over year is that it “puts the Fed on track to follow what the Brazilian central bank did,” which is to raise rates above the inflation.

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