The Fed raised interest rates today by the 0.75% that the markets had been expecting. Wall Street has rallied. Why?
After all, all risk assets are ultimately priced off the risk-free return from short-term U.S bonds (notes), whose yields rise when interest rates go up.
This hike comes after a similar sized one a month ago and a half a per cent rise in May. Together they constitute the most aggressive monetary tightening since the cycle that began in 1981.
Furthermore, the Fed began shrinking its $9 trillion balance sheet last month with its quantitative tightening (QT) program. This reverses the money printing of quantitative easing. By making money in the financial system scarcer, QT will -like interest rate hikes- push up bond yields, everything else equal.
The answer to the market’s joy is two-fold. First, forward guidance from the Fed. The 0.75% hike surprised no one. This is deliberate. The Fed has made it clear it will no longer offer a put on the stock market (i.e., ease policy when stock markets fall), but it has wanted to avoid financial market disruption.
However, Fed Chair Jay Powell did say today that in future months policy will be signposted less clearly, so the central bank does not find its hands tied. We may see the return of surprises over the coming months, for good and bad.
Second, there are growing signs from economic leading indicators that the combination of inflation and higher interest rates is cooling demand.
For example, the S&P Global Purchasing Managers Index (PMI) for July came in at 47.5 last week; anything below 50 indicates reduced order and an economic contraction. It had stood at 52.3 in June.
This helps explain the stability in recent weeks of the long end of the Treasury yield curve, which is more sensitive to growth and inflation expectations.
Inflation expectations are also coming down. The five-year/five-year forward inflation expectation rate, which tells us what investors think inflation will average at over five years starting in five years (i.e., 2027), stands at 2.14% – a level last seen in March.
It seems bond investors believe that the Fed will succeed in taming inflation, and equity investors have perhaps not only already priced in a coming economic downturn but are beginning to bet on the recovery on the other side.
Further rate hikes are a certainty. The new target range for the Fed funds rate is 2.25% to 2.5%, the futures market is looking for the peak to be at around 3.3% – to be reached in December. But their extent will depend on month-by-month inflation, labour market and leading indicator data.
Stock market investors will be hoping for weakness in these numbers, allowing rates to peak at a lower level than currently expected, and the coming economic downturn to be relatively shallow.
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