Markets positioning ahead of FOMC decision

The U.S. Treasury curve remains inverted — a historical signal of a recession on the horizon — deepening the challenge that Federal Reserve faces to control inflation without pushing a weakening economy into recession, as traders position ahead of the Federal Open Market Committee’s rate hike decision Wednesday.

The municipal market has been quiet this week, tepidly following along with the stronger moves in USTs 10 years and out Tuesday, as all markets await the Fed’s decision.

Economists expect the FOMC to raise interest rates 75 basis points on Wednesday, although a full point hike could be on the table.

A 75-basis-point increase would “put the fed funds rate into the upper end of the committee’s estimate of ‘neutral,’ meaning the short-term rate is neither providing accommodation to the economy nor suppressing it,” said Wilmington Trust Chief Economist Luke Tilley.

The Marriner S. Eccles Federal Reserve building.

Bloomberg News

While the market upped its expectations to 100 basis points after the consumer price index showed inflation continued accelerating, and Fed presidents Raphael Bostic of Atlanta and Loretta Mester of Cleveland suggested the panel would consider a full-point rise, Gov. Christopher Waller and St. Louis fed President James Bullard “both suggested support for 75bp hikes, suggesting 100bp is far from a done deal,” he said.

Additionally, Tilley noted, after the June 75 bps increase, Chair Jerome Powell said such moves would not be common, “suggesting that the bar for a 100 bp hike will be high.”

Indeed, in June Powell said he’d need to see “compelling evidence” that inflation was falling to slow rate hikes, said David Page, head of macroeconomic research at AXA Investment Managers. That was “clearly not the case in July.”

Weakening economic activity and a dip in long-term inflation expectations “should dissuade the Fed from following the Bank of Canada’s 100 bps example, which some in markets still consider,” he said.

In the post-meeting press conference, Page said, Powell “has to suggest no let-up in the Fed’s bid to restore price stability, but also be careful not to deliver another tightening in financial conditions which could tip the economy into recession. Getting the balance just right will be as difficult as the Fed’s broader attempt to deliver a soft landing.”

The BNP Paribas Markets 360 team agrees 75 bps is likely, followed by a 50 bp hike in September and 25 bps each in November and December.

“With realized price data worsening since the June meeting, we expect Chair Powell to maintain a clear hawkish resolve,” The BNP team said. “But he could lay the groundwork for more balanced messaging later this year as slowing activity data more prominently influence policymaking.”

And although the 2s10s UST curve has inverted, they said, “this is not the financial signal Fed officials are most focused upon, in our view,” and that would be the near-term forward spread, which “remains upward sloping. However, the forward curve implies inversion and rising recession risks by the fall.”

Still, they said, “a hard landing can be avoided … but it’s a close call.”

While there’s still a 25% chance of a 100-basis-point jump, Jim Caron, chief fixed income strategist at Morgan Stanley Investment Management, reminded “75 bps is still a very large move by historic standards and sends a strong message.”

But whichever way the Fed goes, what matters more “is how Powell communicates the path of Fed hikes in the future,” he said.

“It seems that the Fed is tightening aggressively into a slowing economy but they prefer to risk a hard landing or recession in order to rein in inflation risks,” Caron said. “As a result, the path of rate hikes will be closely linked to the path of inflation. The Fed has mentioned they need to see core inflation fall sequentially on a month-over-month basis. So far, this isn’t happening.”

The rising inflation numbers are “problematic for the Fed,” he said, “because despite all the rate hikes and prospective rate hikes they still have not seen progress toward their target goals for inflation.”

And while inflation is driving the big hikes, Wells Fargo Securities Chief Economist Jay Bryson, Senior Economist Sarah House and Economist Michael Pugliese ask, “once inflation does begin to moderate, how low does the FOMC need to see it go, and at what cost to the labor market, before the Committee stops tightening?”

They suggest core PCE inflation would need to drop to 3% or lower, “even if that brings higher unemployment,” they said.

And stagflation remains a concern, said Phil Orlando, chief equity strategist at Federated Hermes. “Despite a strong labor market and positive consumer spending data, the ugly combination of soaring inflation, slowing GDP growth, plunging business and consumer confidence, and aggressive Federal Reserve tightening has increased stagflation fears,” he said.

But, he noted, “it’s possible that inflation could be peaking.”

As for the fed funds rate may “peak at 3-4% by the end of this year,” Orlando said, depending on whether the Fed declares victory over inflation at the Jackson Hole symposium and telegraphs a downshift in fall rate hikes.”

Scott Anderson, chief economist at Bank of the West, sees 75 basis points at this meeting “with another 50 basis point move in September, and likely finishing the year with another two quarter-point rate hikes in November and December” as it tries to control inflation.

“The Fed has continued to lose ground [in the inflation fight] despite 150 basis points of rate hikes since March,” he said. “The June inflation data revealed an unwelcome and unexpected acceleration in inflation from a level that was already much higher than the Fed can tolerate.”

With inflation so high, Anderson said, “the FOMC doesn’t have the luxury to respond to slowing demand and rising recession risks yet.”

Economic data have deteriorated “at an alarming pace,” he noted, and the growth outlook is “ominous.”

“Until this economic weakness shows up much more prominently in the U.S. employment and unemployment data or inflation data, the FOMC’s tightening path will remain on auto-pilot,” Anderson said. “It feels a bit like one of those bad horror movies where the creepy music is already playing, but the character continues to walk into the seemingly abandoned house. You know this isn’t going to end well though you’re not yet sure what is about to happen.”

 But inflation remaining high doesn’t mean the Fed policies aren’t working, said Ed Al-Hussainy, senior interest rate and currency analyst at Columbia Threadneedle Investments. “It takes time for higher interest rates to work their way through the system to knock down demand and put downward pressure on prices. The question is not whether — but how quickly — inflation will drop back toward 2%.”

Signs suggest the policies are effective, he said, pointing to slowing wage growth, rising 10-year Treasury yields and higher mortgage rates.

The Fed, Al-Hussainy said, is focusing on inflation expectations to analyze consumer behavior. “With its reputation on the line, we think that the Fed will do whatever is needed to keep inflation expectations from becoming unmoored.”

Markets are eying the terminal rate. The Fed “doesn’t have the luxury of time, and the cost of getting inflation wrong is too high,” he said.

“This will likely mean the Fed will move more quickly and aggressively. For investors, this could mean continued uncertainty and higher volatility going forward.”

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