The Fed could give the market a huge surprise this week

The FOMC meeting on Wednesday, December 14 will be an important event as it will end the rapid process of raising rates to catch up with inflation and move into the next phase, focusing on level and duration long.

Listening to Fed officials since the November FOMC meeting, it is clear that the Fed’s forecast rate hike path will be higher than it had at the September FOMC meeting. At that time, the Fed saw the maximum terminal rate at 4.6%. Rates are likely heading much higher than what the market has forecast for 2023.

The problem is that the market does not believe the Fed and currently sees rates at just 4.6% by December 2023.

Much higher, much longer

A 50 basis point rate hike at the December meeting was well telegraphed, and Powell confirmed it during his Q&A at the Brookings Institutions on Nov. 30. At least 6 Fed governors have openly noted that they see rates peaking above 5%, and while Powell may not have indicated where he sees the terminal rate, he said he does. sees higher than the September projection. Additionally, Fed board members like Christopher Waller have suggested that rates still have a long way to go and are among the most hawkish members of the Fed. Furthermore, Loretta Mester estimated that the market price of a peak rate of around 5% was not far off.

The St. Louis Fed’s Jim Bullard thinks rates need to rise between 5% and 7% to be restrictive enough to kill inflation. Meanwhile, the San Francisco Fed’s Mary Daly sees rates at 5% as a good starting point. The Atlanta Fed’s Raphael Bostic sees rates between 4.75% and 5%. The Richmond Fed’s Thomas Barkin notes that rates may need to rise above 5%, while Neel Kashkari sees rates above his September projection of 4.9%.

So if there were only 6 FOMC members that saw rates above 5% at the September FOMC, there will likely be at least nine now, and likely several more at the FOMC meeting in September. December, which will signal that rates should be in that 5 to 5.25% region for the peak terminal rate.

If more evidence is needed, this Wall Street Journal article follows the jobs report “suggesting” that the Fed would raise rates above 5% in 2023. Then another article came out on December 5, which again “suggests” that rates will top 5% in 2023. The WSJ has often telegraphed Fed monetary policy in 2022, such as in June before the Fed’s first 75 basis point rate hike.

Given the message that rates should be at least 5% and likely higher, it is highly likely that the Fed will illustrate its projections through the December dot plot by noting a terminal rate for 2023 at 5, 1% or 50 basis points higher than the September projection. for 2023.

The market does not believe the Fed

Of course, that would go against the market, which currently sees the maximum terminal rate around 4.9%, and then the Fed cuts rates to 4.58% by December 2023, which is lower than the Fed’s September projections of 4.6%. The market doesn’t think the Fed will hold rates above 5% for all of 2023, despite Fed officials constantly broadcasting that message for months.

Perhaps that’s the reasoning behind Powell’s apparent shift in positioning at the Brookings Institution, where he appeared to let the market slide regarding the recent easing in financial conditions. Instead, he focused on telegraphing the pace of rate hikes slowing from 75 to 50 basis points. He knew he could also push back the easing of financial conditions two weeks later at the December FOMC on the back of projections pointing to a longer-term upside, which the market was unwilling to accept.

Financial conditions need to tighten

From all points of view, financial conditions have eased considerably since mid-October. The easing of financial conditions does not help the overall cause of the Fed to maintain a policy restrictive enough to bring inflation down.

If the Fed can deliver this message of a terminal rate of 5% or more until the end of 2023, we will find that the 2-year rate is too low, which will have to rise. Since the summer, the 2-year rate has been trading at a discount to December’s Fed Funds Futures of 10 to 25 basis points. So if the Fed can convince the market that it sees the fed funds rate at 5-5.25% by the end of 2023, then it seems likely that the 2-year rate could trade up to 4 .8% to 5%.

This would likely lead to a further steepening of the yield curve and a deeper inversion of the 2-year to 10-year spread, with market prices at higher risk of recession and rates simply remaining higher for a period. longer.

This would likely help reverse much of the weakness in the dollar index and could potentially push the index higher and towards 110 over time.

It should also boost the VIX as traders look to add more protection on the heightened risk of excessive Fed tightening. The VIX has already started to rise since the Fed minutes were released just a few weeks ago, which also heralded a higher stance for longer on monetary policy in 2023.

A strong dollar, higher rates and higher implied volatility should tighten financial conditions. This will be a huge headwind for stock prices, causing stocks to reverse almost all of the gains seen since October lows and potentially closing technical gaps at 3,745 and 3,580.

Is it likely to materialize at the time of the publication of the FOMC statement or the press conference? It’s impossible to say because it will depend on where the implied volatility levels are and if the implied volatility is high enough to create a short compression once IV crashes after the news. As of Dec. 9, IV was relatively high at nearly 31% for the Dec. 14 options expiration, and is only expected to rise further as we approach next week’s meeting.

Could lose control

If the Fed fails to take control of the narrative and prove to the market that it plans to raise rates to 5% and keep them there in 2023, it risks losing control of the market, which will lead to an easing additional financial conditions as rates fall, the dollar weakens, implied volatility drops and stocks climb higher.

Further easing of financial conditions would likely lead to lower mortgage rates, which would boost the housing market. Meanwhile, a weaker dollar would raise commodity prices and boost import prices, reversing much of the Fed’s 2022 achievements.

That’s why the Fed needs to stay tough throughout the point plot and press conference if it’s serious about bringing inflation down and chilling the workforce.