What if the Market Has Misread the Fed?
Michael Kramer | Dec 09, 2022 21:47
- Focus is likely to shift from the pace of rate hikes to their destination at the upcoming Fed meeting
- Currently, the market is pricing a significant amount of rate cuts in 2023.
- This may come at odds with what the Fed sees.
The upcoming Fed meeting is likely to deliver investors plenty to talk about. Jay Powell has already met the market expectations for a possible downshift to 50 bps rate hikes at the December FOMC meeting. However, after that downshift, the focus will shift from the pace of rate hikes to their final destination.
At least for now, the Fed Funds Futures seems content with the Fed pushing rates to about 4.9%. This is significantly less than what the futures were looking for at the last Fed meeting. On November 2, the futures market saw the rate peaking at 5.07%. On top of that, the futures are now pricing in steeper and faster rate cuts.
After a year of rate hikes and a year of forward guidance, one would think that the Fed and the market would be at the point where everyone agreed. That is not the case. Powell and other Fed board members have notably discussed that they see rates going higher than indicated at the September FOMC meeting. The projections in September were calling for a peak terminal rate of 4.6% then. Now, the talk has been as high as 5% to 5.25%.
Instead, the Fed Funds Futures market is pricing in a peak terminal rate of 4.92% by May and pricing in rate cuts that bring the Fed Funds rate back down to 4.55% by December. This implies that there may be mispricing in the market by as much as 50 to 75 bps, which is meaningful because the 2-year Treasury rate is probably too low.
h2 A Potential Mispricing/h2Not only that, but it possibly also means that the entire market is mispriced from equities to the dollar, as the market has focused on the Fed’s overtightening and needing to cut rates sooner narrative. That potentially means that the recent weakening of the dollar has been too much, and the recent rally in the equity market has been too high.
It will put even more emphasis not on the pace of rate hikes in the future but on where the Fed sees the terminal rate versus the market. Everything from the Fed meeting onward is likely to hinge on how good of a job Powell can do with convincing the market that rates will rise to 5% and potentially be held there for all of 2023. If he can do that, there is probably a very big mispricing in the market currently, which suggests that rates go higher, the dollar strengthens, and financial conditions tighten.
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