Expect Interest Rates To Stay Higher For Longer (SP500)

Many investors are looking to the monthly consumer price index reading from the Bureau of Labor Statistics and the monthly Federal Reserve meeting to help keep the market rally going this week. With some already expecting the inflation report to cause trouble, I believe the Fed may trigger a market selloff with its interest rate decision on Wednesday.

While the consensus seems to be the Fed will raise interest 50 basis to 4.25-4.5% this week, the consensus for 2023 seems to be a bit muddier. The recent market rally has been fueled with the optimism of lower interest rates, as the long end of the Treasury yield curve has seen rates drop by 50 to 70 basis points since the last Fed meeting. Lower rates inversely mean higher prices, hence the market rally.

Fed fund futures tell a similar story, but less so than the Treasury markets. These contracts are traded based on the market expectations for what the Fed will do. The trade price deducted from 100 is the implied interest rate on the contract. Currently, the futures market has the Fed topping off at near 5% in mid-2023. The futures market has also backed off its 52-week high of interest rates, which was recorded on November 4^th, just after the last CPI report. The decline in the Fed funds futures is only one third (28 basis points) that of the long Treasury yields.

The problem with current market optimism is that it’s not founded in what the Federal Reserve is communicating. Since 2011, the Federal Reserve has released economic expectations on a quarterly basis. These data points in growth, inflation, unemployment, and fed funds rate have served as good barometers for what data the Fed is seeking to change its decision making. Unfortunately, all trends are pointing to higher interest rates.

First and foremost is that inflation is nowhere under control. The Fed’s own projections for 2022 show a constant uptick in core PCE expectations for the year, terminating at 5.4%. The Fed’s 2023 inflation expectations are more tepid, but can we really expect inflation to cut in half next year when it has barely declined in the second half of 2022? I believe the Fed is going to take a hard look at its 2023 PCE projection in this week’s meeting and the revised expectation should be well over 3%.

Next, the Fed has not slowed down on its near-term projection for interest rates. For 2022 and 2023, the Fed constantly increased its expectations for the Fed funds rate, with the 2023 rate forecasted at 4.6%. The Fed has rates dropping after that to its long-term target rate of 2.9% after 2025, but this is the same Fed that had the fed fund rate in 2023 at 1.5% a year ago! I’m expecting the Fed to raise its 2023 interest rate expectation to 5% or higher, causing Fed funds futures curve to push higher and flatter.

Don’t look for the lack of economic growth or higher unemployment to necessarily mean a rate reversal for the Fed. Based on their own quarterly projections, the Fed has economic growth estimates nearing 0% this year and at 1.2% for next year. In terms of unemployment, the Fed has moved its 2023 projection from 3.5% in March to 4.4% in September (versus the current unemployment rate of 3.7%), demonstrating that it will tolerate higher unemployment to stamp out inflation.

Overall, I believe interest rates will go higher and remain higher for longer than the current market expectations forecast. Investors should expect further volatility as this reality comes to light and park cash on the sidelines for the emerging value opportunities.

Many investors are looking to the monthly consumer price index reading from the Bureau of Labor Statistics and the monthly Federal Reserve meeting to help keep the market rally going this week. With some already expecting the inflation report to cause trouble, I believe the Fed may trigger a market selloff with its interest rate decision on Wednesday.

While the consensus seems to be the Fed will raise interest 50 basis to 4.25-4.5% this week, the consensus for 2023 seems to be a bit muddier. The recent market rally has been fueled with the optimism of lower interest rates, as the long end of the Treasury yield curve has seen rates drop by 50 to 70 basis points since the last Fed meeting. Lower rates inversely mean higher prices, hence the market rally.

Fed fund futures tell a similar story, but less so than the Treasury markets. These contracts are traded based on the market expectations for what the Fed will do. The trade price deducted from 100 is the implied interest rate on the contract. Currently, the futures market has the Fed topping off at near 5% in mid-2023. The futures market has also backed off its 52-week high of interest rates, which was recorded on November 4^th, just after the last CPI report. The decline in the Fed funds futures is only one third (28 basis points) that of the long Treasury yields.

The problem with current market optimism is that it’s not founded in what the Federal Reserve is communicating. Since 2011, the Federal Reserve has released economic expectations on a quarterly basis. These data points in growth, inflation, unemployment, and fed funds rate have served as good barometers for what data the Fed is seeking to change its decision making. Unfortunately, all trends are pointing to higher interest rates.

First and foremost is that inflation is nowhere under control. The Fed’s own projections for 2022 show a constant uptick in core PCE expectations for the year, terminating at 5.4%. The Fed’s 2023 inflation expectations are more tepid, but can we really expect inflation to cut in half next year when it has barely declined in the second half of 2022? I believe the Fed is going to take a hard look at its 2023 PCE projection in this week’s meeting and the revised expectation should be well over 3%.

Next, the Fed has not slowed down on its near-term projection for interest rates. For 2022 and 2023, the Fed constantly increased its expectations for the Fed funds rate, with the 2023 rate forecasted at 4.6%. The Fed has rates dropping after that to its long-term target rate of 2.9% after 2025, but this is the same Fed that had the fed fund rate in 2023 at 1.5% a year ago! I’m expecting the Fed to raise its 2023 interest rate expectation to 5% or higher, causing Fed funds futures curve to push higher and flatter.

Don’t look for the lack of economic growth or higher unemployment to necessarily mean a rate reversal for the Fed. Based on their own quarterly projections, the Fed has economic growth estimates nearing 0% this year and at 1.2% for next year. In terms of unemployment, the Fed has moved its 2023 projection from 3.5% in March to 4.4% in September (versus the current unemployment rate of 3.7%), demonstrating that it will tolerate higher unemployment to stamp out inflation.

Overall, I believe interest rates will go higher and remain higher for longer than the current market expectations forecast. Investors should expect further volatility as this reality comes to light and park cash on the sidelines for the emerging value opportunities.