BofA with the speculation:
A tenuous but remarkable change in communication
We saw a notable change in communication from the Fed in recent weeks as financial conditions have tightened sharply (see Exhibit 1), the economic outlook has deteriorated moderately (see more “stag”, more “flation”) and the threat of runaway inflation appears to have subsided (for now) with a potential peak in YOY CPI back in March. In a 13 May speech, Cleveland Fed President Mester argued that “If by the September FOMC meeting, the monthly readings on inflation provide compelling evidence that inflation is moving down, then the pace of rate increases could slow, but if inflation has failed to moderate, then a faster pace of rate increases may be necessary.” Earlier this week, Atlanta Fed President Bostic said a pause in September might make sense.
The Fed has essentially opened the door to a pause in September, or a downshift to 25bp hikes per meeting (our Econ team’s house call) or possibly 25bp per quarter. All options are on the table, but we expect that a pause will gain increasing sponsorship from Fed members if financial conditions remain tight or worsen, and incoming economic data continues to disappoint. The Fed’s risk-management approach to current policy requires normalizing overnight rates as quickly as possible, but also seeks to avoid hurting the economy with an overshoot in case the neutral rate curve has shifted lower since the last hiking cycle (see Liquid Insight: Fed policy is not as easy as it looks 23 May 2022). A September pause at normal policy levels would allow time to assess the impact of their rapid pivot without sacrificing too much in the fight against inflation.
The Fed paused for a year after their first hike in Dec ‘15 as equity markets corrected in Jan ‘16. The Fed paused again after the Dec ‘18 hike in the midst of an equity market downturn, and then cut 3 times in ‘19. This time around, however, the Fed needs to more fully normalize policy before pausing because of the high level of inflation. In their view, normalizing policy probably means reaching 1.75%-2%, combined with their balance sheet normalization which starts in June. As long as inflation continues to slowly decline, a pause in September we think would result from a combination of slowing jobs growth amidst tightening financial conditions. While it is impossible to know at this time whether these conditions will prevail strongly enough in their September FOMC meeting to trigger a pause, we think the rates market will begin to price higher probabilities of a September pause if the incoming data – both hard data and sentiment data – remain weak and inflation continues to moderate. This should mean lower rates across the curve.
1.75-2% going into the Sep meeting. The Fed will be able to argue that 1.75%-2% is the bottom of the “neutral range” indicated by the median of the long-term dots in their summary of economy projections (see Exhibit 2). The actual neutral rate is not visible and is likely a moving target. The market is currently pricing neutral in the range of 2.5- 2.75% (see Exhibit 3), slightly above the current Fed median (2.4%) but below steady state over ‘16-’19 which was 2.75-3%.
We think the Fed can easily make the case that reaching 1.75%-2% provides a normalization of policy, but not necessarily a final resting place for policy. This would offer an opportunity to assess the impact on jobs and inflation, both of which would need to be softening through the summer for this scenario to arise. While tightening may of course resume later as conditions change, a September pause would likely lead to a large re-pricing of interest rates given that current year-end pricing for the Fed is 2.60% and the peak reached in May ‘23 is 2.87%. If the Fed paused in Sept, the policy rate at that time would likely be 1.83%.
Implications for rates and the curve
The acknowledgement by the Fed of a lower neutral level would decrease the probability of higher terminal rate scenarios, and push back against a view that had been gaining traction in the market for the need to target positive real policy rates near term.
At the moment, the fed funds OIS curve levels off at around 2.5% after peaking at 2.9% in mid-‘23 and the market prices 6.1 hikes in ‘22 and 0.2 hikes in ‘23. In the context above for a pause in the tightening cycle around 2% we break out scenarios based on the level of the mid-’23 terminal rate (see Exhibit 4).
The table in Exhibit 4 changes the forward path of fed funds to generate hypothetical outcomes for term rates shown (assuming Treasury spreads to OIS do not change). A key part of each of the 3 scenarios is the terminal rate – which is the main determinant of 10y and 30y rates (see Exhibit 5). In the table it is defined as the 1y rate 7 years forward. It is likely that terminal would be priced considerably lower if the Fed guides the market to a September pause. But the extent of decline in the terminal rate would drive the curve movement. We can see a steeper or flatter 2y-10y curve depending on how terminal reprices, but in all cases we see significantly lower rates across the curve.
The implication is that a long duration view in 5y rates would likely be the safest play to take advantage of a pause scenario.
The scenarios imply a convergence of 10yT yields towards the fair value range consistent with current macroeconomic fundamentals, which we see around 1.95-225% (see Exhibit 6 and How cheap are 10yT?).The lower end of the range corresponds to fair value that is consistent with US fundamentals and the potential for overseas demand on the UST curve, while the upper end of the range corresponds to fair value consistent with US fundamentals alone. Until overseas demand picks up, we expect USTs to trade closer to the upper end of the fair value range.
The problem is if the Fed pauses while other central bank persist and DXY falls while Chian rebounds then oil is going to go bananas and the Fed will have achieved nothing. To wit:
Recession this year? Blame inflation
In our view, inflation would be the main driver of any potential recession this year. The energy shock from the Russia-Ukraine war has added to already-severely-elevated inflation pressures, draining spending power. Retail gasoline has made new highs this month. The war is also likely to add to already strong food inflation later this year (see: Food Inflation: a highly regressive tax). And we are yet to see the impact of the China lockdowns, which should lead to another bout of upward pressure on durable goods prices in the coming months.
How concerned should we be about weak sentiment? We cannot dismiss the risk that it will add to the cost shock, since sentiment is forward-looking and hard data are always backward-looking. But real spending has held up well over the last year despite a steady drop in sentiment. We think this continues because of i) the ~$2tn in excess savings that consumers have accumulated since the start of the pandemic, and ii) the red-hot labor market, particularly for lower-income workers, who are experiencing the fastest jobgrowth and wage inflation. Another near-term worry is the guidance on layoffs and hiring freezes from some retailers and tech firms. We think some slowing in the labor market is inevitable as500k-per-month job growth is unsustainable. But we do not yet see signs of a broad collapse in hiring. Meanwhile business investment has been strong and housing supply constraints should limit the downside to the sector from the spike in mortgage rates. In summary, we see low risks of recession this year.
Recession next year? Blame the Fed
However, the outlook for 2023 is much more concerning. Last week we cut our 2023 GDP growth forecast to just 0.9% on a 4Q/4Q basis. Although a recession is not our base case, we see a one-in-three chance of a Fed-induced recession next year. Our concern is that the labor market will continue to overheat, potentially setting off a“wage-price spiral” in which price and wage inflation amplify one another. This could keep underlying inflation sticky-high even as goods supply constraints ease and the impact of the war potentially subsides.
If inflation does not come down to 3% or less, the Fed will hike much further than we are expecting. Our forecast has a terminal rate of 3.25-3.50%, but the risks of a hard landing for the labor market and the economy would increase if the Fed had to hike beyond 4%.
This is a very different story from the inflation-driven slowdown concern described above. We think a modest cooling of the data would be welcome news for the Fed. We would be much more worried if the data remained very strong because that would push the Fed to hike even more aggressively going into next year. The longer the boom, the bigger the bust.
Too soon to “talk about talking about” pausing
Earlier this week, Atlanta Fed President said that his base case was that the Fed wouldpause in September after two more 50bp hikes in June and July. The Fed might be forcedto pause if financial conditions deteriorate further, e.g. if the S&P 500 goesinto a deepbear market. But barring that we think a pause would be a policy error. It would lead tosignificant financial easing given that markets are pricing 80bp of hikes over the lastthree meetings of the year. In turn, the risks of economic overheating–and an evenmore aggressive Fed next year–would increase.In our view, it would make more sense for the Fed to move to a 25bp-per-meeting hikingpace in September. Inflation should be slowing by then, but it would still most likely havea 4-handle. Therefore it would be damaging for the Fed’s inflation-fighting credibility tostart talking about pausing in the summer.
Yes, the US economy is slowing fast now. But the Fed is not done if it wants to kill supply-side inflation, owing to the commodity mania.
But will it?