Rate Hikes Are Not Perfectly Priced In

Rate Hikes Are Not Perfectly Priced In

The Financial press has pushed a variety of narratives around interest rate hikes.

  • One narrative is that four 25 basis point increases are priced into the market. Maybe, maybe not.
  • A second narrative that was pushed yesterday was that a 50 basis point increase for the Fed’s March meeting was priced in. Unlikely so in our view.
  • A third narrative was that the Fed will have taken the Fed Funds Rate to 1% by July 1st. Perhaps.

None of these potential interest rate outcomes are perfectly priced into the market which implies that more market volatility is on the horizon.

  • First, the Federal Reserve is not exactly sure what it will do as the Federal Reserve is clearly behind the curve as it relates to price inflation and will have to play catch-up at some point for refusing to take action tightening action in 2021. Therefore, if the Fed does not have perfect visibility into its course of action, how could the market?
  • Second, regardless of the Fed’s future actions, some market participants are bound to be negatively surprised by those actions. Negative surprises translate to investors selling stock.

The Fed will have to take more aggressive tightening action than it is planning today to curb inflation.

  • The CPI understates price inflation and the Fed is aware of this. There is no way that a 1% Fed Funds Rate by year-end 2022 will be sufficient to fight inflation that is likely in the 15% range or higher. Even if we were to use the reported CPI figure of 7.5%, that figure implies a negative (6.5%) real interest rate at a 1% nominal interest rate.
  • The Fed will have to tighten monetary policy significantly more than a 1% Fed Funds Rate to curb inflation. Negative real interest rates reflect highly accomodative monetary policy and the Fed can’t afford to be accomodative as the prices for goods and services continue to rise.
  • With $30 Trillion in debt outstanding, the Fed can’t afford to take interest rates to where former Fed Chairman Paul Volcker did in the early 1980s. The U.S. would not be able to afford to service the interest expense. It will be difficult to take interest rates higher than 3% without cutting some entitlement programs to reduce fiscal outlays.
  • The Fed will be forced to shrink its balance sheet. The Fed’s balance sheet sits at $8.9 Trillion. As the Fed sells balance sheet assets, it simultaneously shrinks the money supply which is a form of tightening monetary policy.

In conclusion, we expect the Fed to play catch-up in 2022 as it relates to tightening monetary policy. Fed policy is likely to unfold in choppy fashion which will cause increasing market volatility as 2022 progresses. Stocks will trade lower on balance and inflation will persist while Real GDP slows. 2022 will not be a banner year for Chairman Powell and the Federal Reserve.