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Evening Brief – 05.19.23

While an end to the Federal Reserve’s policy tightening may be upon us, we’re unlikely to see a sustained across-the-board rally in risk assets when the central bank begins to cut rates.

Firstly, sticky inflation will likely make it difficult for the central bank to ease on anything close to the scale of previous cycles once we do get to an actual policy easing.

The market may anticipate the Fed will fail to get ahead of inflation, causing long-term inflation expectations to rise. This, in turn, could lead to long-term yields remaining at higher than comfortable levels even if the economy begins to slow due to a credit crunch.

The central bank may find itself in a difficult position due to the dual pressures of inflation and the need for the government to continue supporting the economy through fiscal spending.

In the event of a future economic slowdown, possibly caused by a weakening credit cycle, government funding may become more expensive due to high interest rates. This could eventually make it too expensive to issue the amount of debt needed to meet spending requirements without destabilizing bond markets.

The central bank may turn to the Japanese playbook of yield curve control (YCC) – a monetary policy tool that involves targeting a specific rate on government bonds at a particular point on the yield curve – to manage these pressures. The goal would be to keep real rates negative, which could be achieved by keeping the policy rate below the inflation rate.

In other words, it’s difficult to expect the central bank to manage to hike policy rates into meaningful positive real territory (policy rate above inflation) or tolerate the spending and nominal growth impediments of positive real rates at the long end of the yield curve.

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About Joe Palmisano

Joe Palmisano is Editorial Director for Connect Money, where he brings nearly three decades experience of market insights as a financial journalist, analyst and senior portfolio manager for leading financial publications, advisory firms, and hedge funds. In his role as Editorial Director, Joe is responsible for the selection of content and creation of daily business news covering the financial markets, including Alternative Assets, Direct Investment and Financial Advisory services. Before joining Connect Money, Joe was a financial journalist for the Wall Street Journal, regularly publishing feature stories and trend pieces on the foreign exchange, global fixed income and equity markets. Joe parlayed his experience as a financial journalist into roles as a Senior Research Analyst and Portfolio Manager, writing daily and weekly market analysis and managing a FX and US equity portfolio. Joe was also a contributing writer for industry magazines and publications, including SFO Magazine and the CMT Association. Joe earned a B.S.B.A. in Finance from The American University. He holds the Chartered Market Technician (CMT) designation and is a member of the CFA Institute.