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Inside Markets — Terminal Rate

Terminal Rate

February 8, 2023

Terminal rate expectations drift higher as Fed officials answer questions about last week’s strong Jobs Report. The consensus view is that a single report won’t influence near-term policy. However, further indications of tight labor markets could result in the Fed hiking rates beyond levels suggested by the latest dot plot.

The Fed’s Williams said a peak rate of 5-5.25% is still a reasonable expectation. Williams also pointed to uncertainty around the inflation outlook with a bias toward ‘more to do on rates.’ Two more Fed officials are scheduled to speak today and two more on Friday.

The interest rate ceiling has risen by ~30bp since Friday. Likewise, the time to reach terminal rates has been pushed to August from June. Despite all this, equity markets have remained resilient with the S&P 500 (SPX) holding above support at ~4100. It’s possible that investors are becoming comfortable with the economy’s ability to absorb the Fed’s aggressive tightening campaign. The bond market does not see things that way.

The forward curve remains priced for a policy mistake with nearly 200bp of rate cuts expected 24 months in the future. Note, the pain trade dynamic we explained yesterday is only a short-term driver. The disconnect between the two markets will eventually need to be reconciled. Equity markets are behaving as if a new cycle was about to begin, with an imminent reacceleration in money supply driving a steeper yield curve. This hasn’t happened in our lifetime without first experiencing pain in labor and/or credit markets.

Yesterday’s uptick in the Manheim Used Car Index will result in increased attention on tomorrow’s release of weekly jobless claims and inflation expectations in Friday’s Michigan sentiment report. Next week brings five inflation reports with Tuesday’s release of January CPI as the highlight.

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