During this holiday season, I find myself grateful for many things: my family, friends, and co-workers to name just a few. But working in this industry, I also find myself thankful for the way the Federal Reserve steered the economy through the pandemic crisis and the resulting inflationary environment. This is not to say that the situation was handled perfectly. Remember the Fed’s insistence that inflation was “transitory” in late 2021? But, even though higher rates are painful and there’s no telling whether we’ll achieve the elusive “soft landing,” at least we are beginning to see inflation abate.
In March of 2022, the Fed realized that quickly rising inflation was sticky rather than transitory, and that they were significantly behind the eight ball. They responded by rapidly increasing the Federal Funds rate eleven times, from the Covid era low 0% up to the current 5.25% - 5.50%. Inflation has dropped from peak rates, and the Fed has held steady since their last hike in July. This economic stability has not come without a cost, which has been higher rates and bond volatility.
But how has this story played out? It has truly been a “chicken and egg” situation, with the market playing the part of “chicken” and the Fed playing the part of “egg.” Each party waited for the other to move first and reacted to the other’s movements. For most of this hiking cycle, the egg (Fed) has led the chicken (market), with the market underappreciating how aggressively the Fed would attack inflation.
Jay Powell and his merry band of Fed Governors have been consistently stating that policy would remain data dependent and that rates would remain higher for longer. The chicken (market) didn’t believe the egg. In March of 2022, the market (through the Fed Fund’s Futures market) anticipated that the Fed would raise rates to 2.40% by year end 2022. By June of 2022, the market reacted to the Fed’s continued message of higher rates and revised the Fed Futures year-end target to 3.375%. The market was wrong in both instances- the Fed Fund target rate ended 2022 at 4.50%.
The chicken has continued to underestimate the egg. In December of 2022, the market believed that the Fed Fund’s rate would peak just below 5%, and that the Fed would immediately pivot and begin cutting rates by July of 2023. Again, the chicken was wrong. The Fed did not cut rates in July, but hiked and the Fed Fund’s rate is currently at a range of 5.25%-5.50%.
The Federal Reserve has paused since July, but has not delivered the pivot to cutting rates that the market has anticipated since the first of the eleven hikes. The egg has delivered on its promise to remain data dependent and finally, our chicken started to lead. In the third quarter of 2023, the market, not the Fed, took rates higher, this time at the long end of the maturity curve.
However, the chicken may have moved into the lead during the third quarter, as technical considerations impacted the treasury curve. The Federal Reserve is continuing to decrease their U.S. Treasury holdings as the US Treasury is increasing debt issuance. Add in the instability around Congress and the debt ceiling, and we have a recipe for increased rate volatility at the longer end of the curve. While the egg has a tight grip on the short end of the treasury curve, the chicken now appears to be in control of the long end of the treasury curve.
Now we watch the paint dry, and we couldn’t be more interested. The Fed appears in a holding pattern at current levels and the market will attempt to read into ANY change in tone, wording, or information to make its next move. This certainly doesn’t mean that prices and yields won’t move. We’ve already witnessed some market gyrations as the chickens have come home to roost. The 10-year treasury rate increased to 5% in October, before falling back to the mid 4% range in November. Recent economic data paints an economy that is expanding while price growth is slowing, aka, inflation seems to be settling, but is still over 3% when Fed is targeting 2%.
Here’s what we do know: the continued market volatility allows for an opportunity in stocks and bonds. We think that the Fed may be done with hiking for this cycle and that these higher rates (although lower than recent peaks) are attractive. When, and if, the Fed does pivot and cut rates, we should see the long end of the curve drop precipitously. Finally, this is probably the most interesting drying of paint that we will ever have the opportunity to witness.