by Paul Hoffmeister, Chief Economist
Rate expectations since mid-June have become less hawkish, coinciding with the relief rally in equities.
The market is expecting rate cuts next year, but not the Fed.
We highlight three major market risks that could ultimately trigger economic or financial panic.
The S&P 500, up nearly 17% from its lows on June 16, has staged a seemingly impressive rally. As we see it, the general story behind the strong market action is that CPI may be peaking and there’s a growing belief that the Fed will not need to raise rates as much as previously feared.
Indeed, the inflation data may have started to turn for the better. On July 13, the Bureau of Labor Statistics reported that headline CPI for the month of June had increased 9.1% year-over-year; then on August 10, the index showed a slightly lower year-over-year increase of 8.5% for the month of July. With energy prices declining since the end of June, forthcoming inflation data should show further improvement.
With hopes growing about better inflation data ahead and the Fed already having raised interest rates quickly and aggressively, Chairman Powell left the door open in his July 27 post-FOMC meeting press conference about the Committee’s next move in September, saying that it will be data dependent. He said, “As the stance of monetary policy tightens further, it likely will become appropriate to slow the pace of increases while we assess how our cumulative policy adjustments are affecting the economy and inflation.” [i]
The peak in hawkish Fed expectations occurred on June 14, when the fed funds futures market implied that the funds rate would likely be around 3.75% by year-end 2023. By August 1, that expectation had declined to 2.75%; and by the end of last week, it moved only a little higher to 3.25%. It’s no surprise that the “hopeful” shift in interest rate expectations has closely correlated with the June equity market bottom and subsequent rally.
As a result, we may now be in an environment where inflation data will be declining and an end is in sight for higher interest rates. It's certainly possible that the Fed will succeed in achieving a “soft landing” scenario, where the Fed significantly raised interest rates and oversaw declining inflation without tipping the economy into a deep recession.
But we continue to believe that the risk of Fed error is high. As we have indicated before, history is not on the Fed’s side. The Fed’s interest rate campaigns of ’88-’89, ’99-’00, and ’04-’07 each preceded a recession or market panic; while some view Greenspan’s ’94-’95 rate increases as the only exception of recent history. Note, too, that the equity market panic in late 2018 seemed to persuade the Fed to terminate that rate hiking campaign sooner than it was forecasting at the time.
For more cautious observers like us today, the general view is that the Fed will maintain these higher interest rates until something “breaks” in the economy or a financial crisis emerges, at which point the monetary authorities will begin cutting rates to support economic and financial conditions.
What we find revealing or peculiar about current market expectations is that the market is already pricing in a rate cut in 2023. As of last Friday, fed funds futures expected the funds rate to trade near 3.44% by year-end 2022, but around 3.25% by year-end 2023.
This rate cut forecast contradicts the current FOMC position. The FOMC’s projections on June 15 showed that the median expectation by Fed officials for the funds rate by year-end 2022 and year-end 2023 to be 3.4% and 3.8%, respectively. There is a nearly half percentage point difference between the FOMC’s long-term rate policy assumption and the market’s.
What does the market know? Or what is it sensing that creates uncertainty around the Fed’s projections? Or is the market wrong about forthcoming events?
It's more likely that the market, with its innumerable inputs, knows more than the 12-member FOMC committee. From our perspective, we see three major market risks in coming months.
First, the current global interest rate cycle has seen one of the fastest rate rises in recent history. The significant increase in financing costs, alongside rising inflation costs, is squeezing businesses and consumers around the world. This is uncharted territory for the global economy of the last 40 years and will likely lead to a more meaningful economic slowdown than currently appreciated.
Second, it’s possible that we’ll see political turmoil in Europe erupt again, similar to the Greek debt crisis nearly a decade ago. Italy will be holding elections on September 25, and a new coalition government could force another major debate in the euro currency zone about sovereign debt limits and the sharing of debt burdens.
Third, China is facing a major property market slowdown and defaults among development companies. In turn, Chinese investors are increasingly withholding funds from developers, further exacerbating industry and financial conditions. Making matters worse, the country’s Covid lockdowns persist and continue to pressure the economy. China’s central bank surprised markets today by cutting interest rates and injecting 2 billion yuan into the economy. But it’s doubtful that this alone will be sufficient to engineer a broad-based turnaround.
We are pleased that the Fed has recently begun to telegraph forthcoming, data-dependent gradualism. But with inflation still well above the long-term goal of 2% and the unemployment rate at 3.5%, the Fed risks being more “stubborn” than warranted given the major risks on the horizon. Should any of those risks be realized, we could see a panic that ultimately forces the Fed to cut rates, just as the market seems to expect today.
[i] “Fed hikes interest rates by 0.75 percentage point for second consecutive time to fight inflation,” by Jeff Cox, July 27, 2022, CNBC.
DIAL IN FOR OUR MONTHLY
EVENT-DRIVEN CALL
Every 3rd Wednesday at 2:00pm EST
REGISTER FOR CALL
Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of the Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).
Camelot Event-Driven Advisors LLC | 1700 Woodlands Drive | Maumee, OH 43537 // B384
Disclosures:
• Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by the adviser), will be profitable or equal to past performance levels.
• This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors. Camelot Event Driven Advisors can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.
• Any charts, graphs, or visual aids presented herein are intended to demonstrate concepts more fully discussed in the text of this brochure, and which cannot be fully explained without the assistance of a professional from Camelot Portfolios LLC. Readers should not in any way interpret these visual aids as a device with which to ascertain investment decisions or an investment approach. Only your professional adviser should interpret this information.
• Some information in this presentation is gleaned from third party sources, and while believed to be reliable, is not independently verified.
• Camelot Event-Driven Advisors, LLC, is registered as an investment adviser with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply any certain degree of skill or training. Camelot Event-Driven Advisors, LLC’s disclosure document, ADV Firm Brochure is available at http://adviserinfo.sec.gov/firm/summary/291798
Copyright © 2022 Camelot Event-Driven Advisors, All rights reserved.