Economy

November FOMC: Pivot Higher

By: Jan Groen, Oscar Munoz, Priya Misra, Gennadiy Goldberg, and Mazen Issa

November 7, 2022 - 7 minutes

Closeup of a US Federal Reserve System stamp on a US note

The FOMC delivered, as expected, a 75bp increase in the Fed Funds target range to 3.75-4.00%. Fed Chair Powell predictably cited continued strong core CPI and labor market data as a motivation for the Committee to go with a fourth, consecutive, outsized rate hike.

The statement for this meeting got a slight overhaul, geared towards a downshift to a steadier hiking pace. As we wrote in our preview, a target range of 3.75-4.00% would be a level at which the FOMC could be shifting to a more measured path of hikes to start grinding down inflation. The reference in the statement to "lags" in "determining the pace of future increases" was clearly geared to signaling that downshift. The pace of 75bps rate increases was always meant as a front-loading exercise to make up for lost ground earlier in the year and to get the Fed to a more neutral level instead of an accommodative one. Once achieved, the real work of reaching an appropriately restrictive policy stance would begin, hence the phrase "ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time."

We not only witnessed a hawkish downshift by the Fed, but we also heard from a Chair Powell who's very determined to bring inflation down even if this necessitates inflicting a lot of pain to the economy in light of a stubbornly strong labor market. Communicating the downshift was always going to be a challenge given the FOMC's distaste of forward guidance and adherence to "data dependence" but, in the end, the press conference turned out to be masterclass of how to manage expectations. And markets broadly got the message: to expect a slower pace of hikes, but that the road towards the promised land of appropriately restrictive policy will be pointing up and up for a long time.

Changing our Fed Funds rate outlook

Overly strong August and September CPI reports meant that the trailing three-month and six-month core CPI inflation rates are now running at around an annualized 6.5% level, far above the 2.5%-3.0% range that would be more in line with the Fed's inflation target. Even accounting for some slowdown in the monthly pace of core inflation, it will take a substantial period for a return to this ideal 2.5%-3.0% range. And while we are having to cope with these inflationary trends, the labor market continues to defy expectations as, despite 375bps worth of tightening, it remains red-hot with the gap between labor demand and supply at historical highs. This suggests we might be edging closer to an environment where higher inflation expectations become entrenched, and we have seen the early signs of this happening.

To break this dynamic, the Fed needs to slow down the labor market by a lot, and the only means by which it can achieve this is to hike more than what it and anyone else initially expected to be sufficient. We now project to see a 50bps hike in December, another 50bp move in February, followed by two 25bp hikes at the March and May meetings. Consequently, our projected terminal Fed Funds rate moves up from 4.75-5% in March to 5.25-5.50% in May. By the June meeting we expect the FOMC to announce a pause supported by appropriately adjusting its SEP.

This more aggressive than expected hiking path has an unfortunate consequence. The amount of real tightening that we expect now to happen will likely lead the economy to a recession in the second half of 2023. Consequently, we are of the view that by its December 2023 meeting the FOMC would feel the need to cut its Fed Funds rate by 25bp.

Rates Market Implications

Markets struggled to digest the message at the November FOMC meeting, and it was one of the more volatile post-meeting reactions. The initial statement suggesting that the Fed will look at cumulative hikes and account for policy lags was viewed as dovish by investors, with the curve bull steepening as the market's pricing for the terminal funds rate fell to 4.95% from 5.05%. However, at the press conference Powell was much more hawkish by suggesting that the Fed could go further on rate hikes. This pushed the pricing for the terminal funds rate to a new cycle high of 5.07%. By the end of the day the Treasury curve bear flattened on the "hawkish downshift" message from the Fed, with investors pushing 10y yields above 4.1% as real rates drove the selloff.

What next for rates?

Right before the Fed statement, the rates market was priced for 60bp and 38bp of hikes at the December and February Fed meetings, respectively, and a terminal rate of 5.04%. Immediately after the statement was released, market pricing for hikes over the near term declined, but that move was reversed by the end of the press conference. The market is currently priced for 57bp and 38bp of hikes at the December and February Fed meetings, respectively, and a terminal rate of 5.07% by May 2023. Thus, market pricing for another 75bp hike in December is now less than 30%. The market is pricing in the first cut to policy rates at the December 2023 meeting and a total of 105bp of cuts are priced in to 2024.

However, the market should ultimately price in not just the Fed reaction function but also the economic outlook. Chair Powell signaled a terminal rate that is likely to be higher than the previous dot plot implied terminal rate of 4.75%. We now expect the Fed to take rates to 5.5% by May 2023 as inflation remains sticky. But then we expect the economy to slow sharply in 2023 as the full effect of the Fed's tightening policies (rate hikes and QT) are felt. Note that private domestic demand is already slowing as the household savings buffer is getting depleted. In addition, slowing global growth is also a headwind for US growth. Thus, we think that the Fed will end up easing rates more than is priced in.

Updating Treasury forecasts

Given our new Fed forecasts, we also update our US rates forecasts. We tweaked front-end rates to incorporate a higher terminal rate of 5.25-5.50%. We maintain the same trajectory as before of high rates in the front end as the Fed reaches terminal rates in Q2 2023 and that results in a continued inversion in the 2s10s curve through much of 2023. However, we see the 10y rate declining through most of 2023, ending the year around 3.25%, as the market prices in a slowing in the economy which will necessitate significant rate cuts from the Fed in the future.

FX Market Implications

Powell was able to successfully fight back against the budding narrative of a 'dovish pivot' or that a downshift in policy implied that the end to the hiking cycle was near. If anything, this was a pivot higher. We thought that Powell's insistence that there would be no pause to rate hikes was a crucial hawkish development. It is important because it suggests that not only is terminal higher but that it could take longer to get there. That also means that scope to price in easing in late 2023 becomes less of a possibility at least at this point in time. It's still early days whether that will hold true, but the SOFR curve has responded in kind.

We think this is important to fight back against early calls for an inflection point in the USD. We have put forth the notion that the easy part of the USD rally is over. That remains true after this meeting. But it remains premature to look for downside. If anything, we are likely reducing the tail risks around the USD which may help to alleviate G7 FX vols. But, we are now transitioning out of relentless USD upside to putting the onus on other currencies to weaken the USD. That's a tall order with how things are going to look in the next couple of months or so. Moreover, the Fed is making that more difficult with today's hawkish pivot which unequivocally tells us that the interest rate differential against most G10 is even wider than initially perceived.

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Jan Groen
Chief U.S. Macro Strategist, TD Securities

Biography

Jan is the Chief U.S. Macro Strategist and heads TD Securities' U.S. economics research in NYC. His research and analysis cover U.S. and global macroeconomic trends, with a focus on formulating views on the Federal Reserve's rate setting policy, macro data forecasting, and quantifying underlying economic trends. Jan joined TD Securities in NYC in 2022 from the Federal Reserve Bank of New York where he was an Economic Research Advisor. During his 14-year career at the New York Fed he led the modelling of developments in global financial markets and of global drivers of U.S. inflation and economic growth. Before the New York Fed, Jan held several senior economist positions at the Bank of England, where he was amongst others the lead on the statistical macroeconomic forecast effort, and he was a Research Fellow at the Dutch Central Bank. Jan holds a PhD in economics from the Tinbergen Institute at the Erasmus University Rotterdam.

Oscar Munoz
Vice President and U.S. Macro Strategist, TD Securities

Biography

Oscar provides research and analysis on the U.S. economy and financial markets for both internal and external clients. Prior to joining TD Securities in 2018, Oscar worked as a LatAm Economist in New York for four years.

Priya Misra
Managing Director and Global Head of Rates Strategy, TD Securities

Biography

Priya is responsible for the macro calls on the U.S. and global interest rate markets and provides investment advice to clients. She represents TD at the Fed's Alternative Reference Rate Committee (ARRC) and is actively involved in the transition from LIBOR to SOFR. She publishes regular research on interest rates, discussing secular trends as well as trade ideas and manages a model portfolio of recommendations.

Gennadiy Goldberg
Director and Senior U.S. Rates Strategist, TD Securities

Biography

Gennadiy Goldberg is a Director and US Rates Strategist at TD Securities, conducting research and providing market commentary on interest rates and the US economy. Gennadiy focuses on Treasuries, swaps, TIPS, supranational and agency debt, as well as ESG debt.

Mazen Issa
Director and Senior FX Strategist, TD Securities

Biography

Mazen covers all aspects of G10 FX strategy. Previously, he was a Senior Macro Strategist based in Toronto where his coverage had a particular emphasis on Canada. Before joining TD Securities in 2010, Mazen spent several years at BCA Research in Montreal as part of the Global Fixed Income Strategy team. In that role, he was responsible for providing macro analysis and investment recommendations for the developed markets.

Economy

November FOMC: Pivot Higher

Changing our Fed Funds rate outlook

Rates Market Implications

What next for rates?

Updating Treasury forecasts

FX Market Implications

Disclaimer

Biography

Biography

Biography

Biography

Biography

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