Bond market veteran warns markets that there is a major misjudgment of the Fed, and the Fed's rate hike cycle will not stop at 2%

In the eyes of a growing number of wall Street veteran bondmakers, investors are making a major miscalculation: betting that the Fed's key interest rate will be close to current levels at the end of its upcoming rate hike cycle.

Data released Thursday showed U.S. inflation hit a four-decade high before bears swept the market, and traders raised expectations that the federal funds rate would eventually rise nearly 25 basis points to around 2 percent. This still means that the rate hike expected by the market is relatively small and will not reach the peak of 2.5% that the last tightening cycle hit in 2018.

But the pace of the adjustment has led some strategists to bet that broader repricing is just beginning, and investors will realize that the Fed is finding itself in a tougher position than it was four years ago — the economy is now growing twice as fast as it was then, wages are rising faster, and consumer prices rose their biggest increase in four decades in 7.5 percent year-over-year in January.

All of the above could raise policy rates above market expectations, potentially costing equity and bond investors accustomed to soaring asset prices in the era of loose money.

"Our economy is booming, inflation is high, and the labor market is recovering rapidly, and this scenario is very different from the previous cycle," said Michael Darda, chief economist at MKK Partners. He predicts that the Fed's overnight interest rate will peak at around 3.5 percent. "The Fed has moved late. They have to do more. ”

The widely anticipated trajectory of rate hikes is both drastic and relatively shallow, one of the factors preventing further gains in U.S. Treasury yields. It reflects the idea that inflation will wane as the impact of COVID-19 subsides and that the Fed will be constrained by structural factors, including a global savings glut and heavy debt burdens that will make major economies barely able to afford higher interest rates.

"I don't think the federal funds rate will reach the high level of 2018 because during the hike, there will be some conditions in financial markets or the real economy that will cause the Fed to pause and have to stop," said Joachim Fels, a global economic adviser at Pacific Investment Management. "In our new environment, the real equilibrium rate may even be lower than it was before COVID-19. The pandemic has also pushed up debt around the world, and monetary stimulus has pushed up asset prices. ”

More losses

If the Fed does raise overnight rates to 3 percent or more, Treasuries could fall for the first two straight years since at least the early 1970s and could weigh on stock prices, especially rising growth companies that are so highly valued that they are particularly sensitive to rate hikes.

"If the Fed is really aggressive, pushing up eventual interest rates and shrinking the balance sheet, then the stock market will be under a lot of pressure for a while," said Peter Tchir, head of macro strategy at Academy Securities.

Even if the Fed raises rates by 50 basis points at a time, market rates are still well below what is seen as enough to cool the economy. Although the 10-year Treasury yield has risen above 2%, it remains negative with an inflation-adjusted rate of about 2.5% given that the bond market expects inflation to be around 2.5% over the next decade.

Negative real yields suggest monetary policy remains accommodative despite growing concerns about the risk of an overheating economy and inflation becoming more entrenched than expected.

"Inflation has now gone," said John Thorndike, GMO's co-head of asset allocation. But "the market narrative is that inflation disappears and markets often struggle to cope with change." More likely, during this cycle, real yields and policy rates need to be above inflation. ”

History cannot be used as a lesson

Former head of marketing at the New York Fed, D. E． Brian Sack, director of global economy at Shaw Group, believes the Fed will need to raise the federal funds rate above market expectations. Goldman Sachs economists share the same expectations.

Goldman Sachs economists have raised their expectations for rate hikes this year to seven, or 25 basis points per meeting. In early Asian trading on Friday, currency market pricing showed the same expectations.

Rebecca Patterson, director of research at Bridgewater Investments, said a lack of housing investment, commodity costs and tight labor markets would keep price pressures high.

"We're going to be in a situation we haven't seen in decades — inflationary pressures are going to continue," she said.

While inflation is expected to decline in the coming months as supply issues are resolved, the continued trend in rent and wage increases is likely to continue to weigh on the Fed. A recent survey by the National Association for Business Economics showed that price increases are becoming more common, wages are soaring, and most companies report shortages of skilled labor.

Such economic reports have led Darda, chief economist at MKM Partners, to warn clients every day not to draw on the Fed's recent history to judge its course of action.

This article originated from the financial world