Market Continues to Price in a More Aggressive Hiking Schedule. Who will be Right?

The market continues to price in a sooner and more frequent rate-hiking schedule than the Fed. Investors also are showing elevated concern over inflation which has something to do with that quicker rate-hiking scenario. We delve into those two related items in more detail below.

Meanwhile, the October jobs report could provide a bounce from the so-so September. We ponder that possibility as initial claims for last week, which is the survey week for the employment report, reached a new pandemic low of 290,000 versus 297,000 expected and 296,000 in the prior week. Continuing claims were lower as well and the number of people receiving some form of unemployment payment dropped to 3.4 million.

Recall in early September, before the expiration of the emergency programs, that number totaled more than 12 million. One would think some of those 8 million people losing payments in the past month have ended up in the employed category in October.

In our podcast this week we chat with Ryan Harbry, from StrategyCorps to get his thoughts on how banks can acquire more primary relationships, move away from punitive fees, and improve their overall retail business model.  The iTunes link can be found here and the Spotify here.

 


Market Has Two More Hikes By December 2023 Than the Fed

The guessing game on when the Fed will begin rate lift-off is in high-gear now that the tapering announcement is all but done. The November 3 FOMC meeting is where we’ll get the formal details for tapering but Fed Chair Powell has already been clear that they want the tapering to finish by mid-2022. With that clarity we don’t think the announcement will trigger much selling.  To the contrary, it could invite a bit of buying as the event risk is hurdled.

We also think Powell will try to separate the end of tapering from the start of hiking, in that one doesn’t immediately follow the other. That may be a tough task for the Chairman as the market is already well down the road of rate-hiking speculation.

Source: Bloomberg

For example, the graph is Fed Funds Futures expectations for December 2023. The recent spike to 1.45% is partly a result of the updated dot plots from the September FOMC meeting along with other Fed comments focused around inflation concerns. Recall, the latest dot plot had the funds rate reaching 1.00% in December 2023, comprised of one hike in 2022 and two in 2023. Investors, meanwhile, think inflation concerns will eventually force the Fed to be more aggressive as they have two additional hikes through 2023. They also have the first hike priced in around September 2022. That would be just a few months after tapering is completed. If Powell is uncomfortable with that outlook he will have the chance to voice his concern following the November FOMC meeting. Keep an ear out for that.

Also, in recent years when the Fed and market diverged in their forecasts it has typically been the Fed eventually coming around to the market’s outlook. Will that be the case this time? Again, if Powell is uncomfortable with the market’s current outlook on the timing and pace of future hikes he will have the opportunity to say something. If he’s mum on the subject that invites the argument that he tacitly agrees which could solidify the pricing of the more aggressive hiking schedule.

 


TIPS Breakeven Inflation Rates Set New Cycle Highs

Much of what has driven fed funds futures higher and faster than Fed forecasts has been concerns over inflation. While the Fed has conceded that pandemic-driven price spikes haven’t been as transitory as they had initially thought, investors are showing an increased level of concern over inflation. Part of that concern is reflected in TIPS breakeven rates that have moved to new cycle highs. The 10yr breakeven rate is now at 2.61% and the 5yr breakeven rate even higher at 2.83%.

Source: Bloomberg

Recall that Treasury Inflation Protected Securities (TIPS) provide two sources of income to the investor. The first is a small coupon payment and an additional payment tied to the CPI. Pricing of TIPS allows one to tease out the inflation component that will provide the same yield as a nominal Treasury of similar maturity. That’s where the inflation breakeven terminology comes from.

As the graph shows, those inflation expectations for both the 5-year and 10-year periods have moved to new cycle highs. Investors, it seems, are less convinced the price spikes will recede as much and as quickly as Fed forecasts do. Now the Fed has multiple floors filled with PHD economists who help develop the inflation forecasts, so betting against them can be a treacherous thing. One thing is certain, however, and that is by the time tapering is completed in mid-2022 the transitory or not transitory inflation question will be more clear to all.


Agency Indications — FNMA / FHLMC Callable Rates

Maturity (yrs) 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year
0.25 0.36 0.75 1.05 1.40 2.10 2.56
0.50 0.34 0.72 0.99 1.29 1.96 2.45
1.00 0.34 0.69 0.95 1.25 1.86 2.32
2.00 0.68 0.90 1.17 1.75 NA
3.00 1.12 1.68 NA
4.00 1.64 NA
5.00 1.60 NA
10.00 NA

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Published: 10/21/21 Author: Thomas R. Fitzgerald