We have barely embarked on a rate hiking cycle but may have already priced in too much tightening.
I’m reminded of a quote from former St. Louis Fed President Bill Poole that was on my bulletin board for years:
Poole believes people in the press and financial markets are usually asking the wrong question. ‘What is important is not the policy action at the next FOMC meeting,’ he said, ‘which is typically what people want to know, but the policy regularity that will extend across many FOMC meetings, which is what people should want to know.’
Right now market participants are focused on the May 4 FOMC decision and whether it will be a 25 basis point hike or 50 basis points. Implied pricing currently points to a 81% chance of 50 bps.
What's more important is where rates are terminally headed. Right now the market is pricing in 3.25% for the Fed and Chicago Fed President Charles Evans on Friday outlined a path to get there with steady hikes for a full year. Whether that's front-loaded or back-loaded is much less important than the terminal rate.
What's also notable is that the SOFR curve prices in rate cuts starting around the end of 2023.
Economists at CIBC argue that a more likely path is that the Fed loses its appetite to hike around 2% and rates move sideways from there with the Bank of Canada following a similar path.
They note that inflation is a lagging indicator and that in the past 25 years of rate-hike cycles, the Fed always pauses ahead of the peak in inflation because they foresaw a slowdown in economic activity.
We suggest that the aggressive tightening trajectory currently priced in by the market is ignoring these past lessons, and incorrectly assumes that both the Fed and the Bank of Canada will chase inflation until the bitter end. While central banks are now committed to higher rates, we see a much earlier pause to the hiking cycle as Powell and Macklem start to pay closer attention to a slowing economy, as opposed to continuing to chase a lagging indicator. Just to be clear, the Fed and the Bank don’t need to see a full recession coming in order to pause a rate hiking cycle. A slowdown in growth would suffice, and that can happen at rates below where the market is currently pricing.
So while the market is hyper-concerned about rising yields, with 2-year notes already at 2.5%, we may already be at (or near) the peak. It will take some cooler inflation numbers for the market to come around to that idea but there is plenty of reason to believe inflation will flatten out late this year. If the market shifts to pricing in a terminal rate at 2% instead, it will be a tailwind for risk assets and headwind for the US dollar .