Treasury Yields Were Hung Without a Care…
The market’s reaction to the Fed’s dovish pivot last week is withstanding the pushback from former and current Fed officials.
The Fed set off a frenzy in financial markets last week when it appeared to endorse the view that rate hikes were a thing of the past and next year would deliver multiple rate cuts. The median forecast in the summary of economic projections of Fed officials sees the Fed funds rate falling to 4.6 percent by the end of next year, 50 basis points lower than the September projection and 75 lower than the current target.
The market moved by immediately knocking more than 20 basis points off the yield on 10-year Treasuries, bringing it down below four percent, and almost 40 basis points of two-year yields. While it is tempting to see those kind of extreme moves—and they are extreme for the U.S. Treasury market—as the products of momentary irrational exuberance, the shifts have been endorsed by the market in the days since. As of Monday, the 10-year yield is 3.95 percent and the two-year is 4.45 percent, both essentially unchanged from Friday.
It also priced in March rate cuts and five or six cuts next year, according to the CME Group’s Fedwatch tool. (Even seven cuts is currently enjoying a one-in-four chance). The actual median forecast of Fed officials of 4.6 percent is currently an extreme outlier at 2.2 percent, not much better than the 1.7 percent odds given to the fed funds rate being cut at every single meeting next year and below the 22 percent chances implied of seven cuts next year.
Those yields have even withstood pushback from New York Fed President John Williams and Atlanta Fed president Raphael Bostic, both voting members of the Federal Open Market Committee next year. (The New York Fed president is always a voting member, and the Atlanta Fed rotates into the role after 2023 comes to a close.) Separately, both Fed presidents pushed back on the expectation that the Fed could cut as soon as March.
…in Hopes That St. Rate Cuts Soon Would Be Here
The criticism of the expectation of a March cut is implicitly a criticism of the many cuts position. The Fed meets only eight times each year. If the Fed were to hold off on hiking at both the January and March meeting, that leaves only six meetings for rate cuts. Unless the Fed were to super-size cuts to more than a quarter-of-point at a meeting, there’s only room for 150 basis points in cuts next year.
Monday brought even stronger criticism of the idea that the Fed will cut rates early and often next year. In a Bloomberg opinion column, former New York Fed President William Dudley pointed out that there was a lot that could go wrong with the Fed’s apparent bet that it can defeat inflation without forcing the economy into a recession.
“The US Federal Reserve and its chair, Jerome Powell, are betting that they can have the best of both worlds — that they’ll be able to defeat excessive inflation without forcing the economy into recession. I hope it goes well,” Dudley wrote. “Unfortunately, there’s still a significant chance it won’t.”
Wall Street and Broad Street signs are seen as the New York Stock Exchange building is decorated for Christmas in New York City on December 16, 2020. (Tayfun Coskun/Anadolu Agency via Getty Images)
Yule Be Sorry
If the Fed’s bet proves to be wrong, the Wall Street bets that are essentially doubling down on the Fed’s position could be truly disastrous. These dramatic moves in Treasuries could need to be unwound if the Fed determines it needs to hold off on rate cuts—as would the bid up in stock prices premised on lower interest rates. If inflation proves resilient enough to require additional rate increases, the unwinding of the rate cut Santa rally of 2023 could be very painful.
There are already warning signs that the economy is not slowing as expected. Homebuilder confidence increased for the first time in five months in December. Consumer confidence is soaring. November retail sales smashed expectations. S&P Global’s purchasing managers surveys showed economic activity expanding at the fastest pace in five months. The money supply is no longer contracting. Gallup’s poll says consumers have increased the amount they plan to spend on holidays as the shopping season has progressed. GDP Now jumped to 2.6 percent fourth quarter growth last week.
The market, however, has taken even less notice of the data than it has the pushback from Fed officials.
