Fed’s Finally Getting Through To The Bond Market

Scott Anderson
Chief Economist
Bank of the West

Jay Powell and the rest of the FOMC must feel like a broken record at this point as the stock and bond markets have largely been tone deaf to the Fed’s message on the likely terminal Fed funds rate and how long they are going to have to keep monetary policy in restrictive territory to ensure that they bring inflation down to their 2.0% target. It took a barn burner January Employment Report and a surprisingly strong December JOLTs report to concentrate the minds on Wall Street that traders might want to rethink their expected Fed funds rate path over the next couple of years, especially the prospect for sharp rate cuts starting in the second half of 2023.

Job Openings On The Rebound
Here is why we think Fed Chair Jay Powell and other FOMC members feel the need to push back hard on the market’s dovish take on monetary policy.

Not only have labor market conditions tightened further in recent months with the unemployment rate hitting a new 54-year low of 3.4% in January, but job openings have also been creeping higher since August 2022 and absolutely popped back above 11.0 million openings in December. The Federal Reserve and most private sector macroeconomists believe we need to get the U.S. unemployment rate well above 4.0% for a prolonged period of time to truly vanquish inflation for good. So on that front the 450 basis points of Fed rate hikes so far don’t even put the Federal Reserve on the scoreboard in cooling down labor market conditions to a sustainable pace.

Financial Conditions Have Been Loosening Since October
Long-term Treasury yields, mortgage rates, and high-yield credit spreads have all dropped sharply over the last several months. This has helped trigger a sizable stock market rally since the beginning of the year and bolstered confidence in the “soft landing” scenario for the U.S. economy.

Rising stock prices, resilient labor demand, and rising nominal wages are bolstering investor and consumer confidence, household wealth, and even increasing demand for home purchases. According to the Mortgage Bankers Association, home purchase applications increased 19.2% in January as 30-year mortgage rates plunged around a percentage point from 7.2% in October to just 6.2% at the beginning of February.

Housing Demand Comes Back To Life
Homebuilder stocks and lumber prices both confirmed the stabilization in housing demand in January. We are forecasting a noticeable bounce in the NAHB Housing Market Index for February with a rebound in January housing starts and permits too when the data get released next week. Jay Powell noted in his post FOMC press conference last week that the Fed needs to see “financial conditions that reflect the policy restraint put in place.” That’s Fed speak for “we need to see tighter financial conditions”.

Fed funds futures are finally catching on that the Fed still has a lot of work cut out for it to achieve their inflation goal, and the path to 2.0% inflation might not be a smooth one. As of February 10th, Fed funds futures were pricing in a terminal Fed funds rate of 5.17%, implying two more quarter point rate hikes before a pause with a year-end expected rate of 4.89%. This is far closer to our own forecast and the forecast coming from the FOMC median than the market was on February 1st after Powell’s last FOMC press conference. On the 1st, the market expected the Fed funds rate to peak at only 4.89% and end the year at 4.4%. So the peak Fed funds rate in the market today is 28 basis points higher than it was right after the February FOMC meeting, while the year-end Fed funds rate is now 49 basis points higher than it was then. The two year Treasury yield has jumped 39 basis points since Feb 1st to 4.50%. These dramatic interest rate moves on the shortend of the yield curve are a large step in the right direction, the market has begun to listen, but rates still have a ways to go to reflect current conditions. A Fed rate cut in 2023 is still a long shot and robust economic data for January give it even less of a chance.

To learn more, check out this week's U.S. Outlook Report.


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