Evening Brief – 10.25.23
Signs of a Rate Peak
It appeared that the Federal Reserve would no longer be increasing interest rates way back in January. But the central bank raised its target rate four times in the months that followed by a total of 100 basis points.
Today, the numbers again leave room for speculation that the rate increases have reached their peak. Lowering interest rates is a discussion for another day; on that score the outlook for easing monetary policy is much weaker. In contrast, there are compelling reasons to believe that the central bank has completed its rate-hiking cycle.
The Federal funds futures contract currently prices in a near-certainty of no change at the next FOMC meeting on November 1, followed by moderately confident estimates of maintaining the status quo at the subsequent two meetings.
In the meantime, the Fed-sensitive 2-year US Treasury yield has been trading in a range, indicating that bond market sentiment is cautiously pricing in a rate peak.
The 2-year US Treasury yield, which is presently at 5.10%, continues to trade slightly below the Fed funds target range of 5.25%-5.50%. This is further evidence that the market is still leaning toward the conclusion of the hiking cycle.
The spread between the yield on the 2-year US Treasury yield and the Fed funds highlights the relative stability. In prior months, the Treasury market overestimated the likelihood of a peak in interest rates, but the market is now returning to this concept. If the downside bias intensifies in the coming weeks, it may be a further indication that rates have indeed peaked.
Moreover, Fed funds relative to inflation is tighter now than in January 2023, when inflation was higher and monetary policy was easier. While this does not imply the Fed’s hiking cycle has ended, it supports the forecast. Another supportive factor is that real (inflation-adjusted) interest rates are higher today compared with January 2023.
A passive tightening policy would have the Fed leave Fed funds unchanged and allow the market to tighten through higher real yields. The principal threats to the peak rate forecast are the resilience of the US economy, particularly if it accelerates, and sticky inflation.