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.