It is easy for the Federal Reserve to talk tough on inflation when the unemployment rate is sitting at 3.5%. However, when faced with rising unemployment and “sticky” inflation—whether wage or rent inflation—remaining higher for longer, the path forward remains uncertain as to what will represent the true terminal rate.

The market anticipated Chair Powell’s comments given the recent hawkish rhetoric from various Fed constituents. The market had priced out its dovish reaction from the July FOMC meeting, and this trend has continued since Jackson Hole. Currently, the market is pricing in a year-end federal funds rate of 3.6%, and a terminal rate peak in March 2023 at 3.8%, trending toward the Fed’s current objective. Most important, the 83 basis points of easing that the market had priced in for 2023 after the July FOMC has been essentially removed. The market now prices only around 30bps of easing, and has pushed that easing to the fourth quarter of 2023 (Fig. 1).

Interestingly, for those economists and strategists that believe the market needs to witness a positive real fed funds rate for the Fed to move to a more restrictive stance, the market currently projects this to occur around the third or fourth quarter of 2023. This is assuming the Fed moves to a 3.5% rate (near the UBS projection of 3.25–3.5%) alongside the consensus projections for CPI and PCE over the next several quarters (Fig. 2).

The real fed funds rate will turn positive sooner if the Fed’s Summary of Economic Projections report shows a meaningful rise in the terminal rate come the September FOMC meeting. This is the one temporary risk to our 3.25% high in 10-year yield for the remainder of the year. However, if in fact this were to occur, we do not believe that the rise in 10-year yield will be sustained, and we continue to recommend increasing interest rate exposure as the 2.75–3.25% will represent the majority of the range into year-end.

With the market repricing over the past few weeks, now anticipating a 3.8% terminal rate, the 10-year Treasury yield only reached a high of 3.13%. Negative term premiums, alongside growth concerns abroad, have capped the 10-year yield for the time being, even as the gates open for quantitative tightening (QT) in September (Fig. 3).

The main impact has been witnessed by the reinversion of the US nominal and real yield curve—a trend that will likely continue over the next several months, potentially reaching or going through the –58bps witnessed in the 2-year/10-year curve on 8 August (Figs. 4 and 5).

Positioning

We closed our preferred positioning on preferred securities, as we felt the large spread compression witnessed following the July FOMC was too aggressive in such a brief period of time, and spreads had compressed over 60bps since inception. We remain neutral on sectors with higher embedded credit and lean toward the up-in-quality sectors such as agency MBS, which once again is now on a spread-tightening path. The expectation that the Fed will sell MBS is well overdone, in our view. The market widened agency MBS spreads over 15bps into Jackson Hole as the belief that Powell would address MBS and QT became a popular view. We disagreed. The sector is now tightening once again, and although we cannot rule out a sale sometime in 2023, we believe it is much too soon for the Fed to act given the headwinds the housing market is currently facing.

Main contributors - Leslie Falconio

Content is a product of the Chief Investment Office (CIO).

Original report - Fixed income update: Jackson Hole, 29 August 2022.