Monthly Cash Review
Could December’s anticipated 50bps rate hike be the last for the Fed? There continues to be a drum beat of “policy error” coming from current market pricing and market experts. As we approach the Fed’s potential pivot point, they are left to decide which is better: stop hiking sooner and leave policy rates steady for a longer period of time, or continue hiking knowing they will be forced to ease rates as economic conditions worsen due to the ‘over-hike’. At the time of this writing, the 2y10y yield differential is -73bps, indicating the Fed has already overtightened. The ten year yield is now below the yield on overnight treasury repo rates.
Historically the Fed has always raised interest rates beyond what was necessary. This is what they must do as their policy rate hikes have a delayed effect on the economy. Because of this, they don’t typically end up staying at peak policy rate for very long. The 25bps rally we saw in 2yr UST after the October CPI report released on November 10th was a clear indication that the market is eager for the Fed’s pivot. A BofA strategist recently updated their forecast that calls for 2yr and 10yr UST yields to close 2023 at 3.25%. What’s not clear is how long the Fed wants to keep monetary policy in a restrictive place before they begin to ease.
There has been considerable rhetoric from various Fed officials telling us they expect policy rates to be elevated for some time. Their fear is the “pulses of inflation,” meaning inflation measures might fall off for a period of time only to surge again. The most commonly referenced period of time of inflation pulsing is the 1970s. CPI from early ’73 to late ’74 rose from ~4% to ~12%. The Fed raised rates by five percentage points in 8 months in ’73 (6% to 11%). They then began easing aggressively in ’75 (~9% down to ~5%). 1974 was a tough year for labor. Weekly jobless claims spiked from the low 200,000’s in 1973 to over 550,000s by the end of 1974. The unemployment rate spiked to 9% by 1975.
So what will happen this time? There is no question there are numerous structural, fiscal, monetary, geopolitical, and labor force differences between the decade of the 1970s and the decade of the 2020s. But the Fed’s reaction could follow a similar path to the 70s: over-tightening followed by over-easing with significant labor force damage along the way. If you think the Fed will overtighten and cause significant labor force damage which will lead to a hard economic landing then it probably makes sense to add some duration. UST 2yr notes look tempting at 4.45%. If it feels more like the Fed will stop their hiking cycle in enough time to not wreak havoc on the labor market and are able to engineer a soft economic landing, the duration extension probably is not as urgent. Perhaps we don’t see the credit market damage that a hard landing could cause, meaning there could be value in corporate debt. The yield break-even calculator remains one’s best friend, and the assumptions that are entered into that calculation are ever more critical as we plot the path of rates in 2023.