A Fed funds rate dislocation

Want to see something scary?

The above chart, via Deutsche Bank strategist Jim Reid, shows how much investors are buying into the short-sharp-shock thesis. Futures are pricing in that US interest rates will peak at 3.39 per cent at the February 2023 FOMC meeting then come back by 0.7 percentage points over the following 12 months. That’s contrary to expectations that inflation will be a problem for a lot longer. As Reid says:

Current market pricing would leave spot real Fed Funds in negative territory throughout this entire hiking cycle. By the time Fed funds futures reach their 3.39% peak in February 2023, consensus inflation forecasts for Q1 2023 still have the CPI reading at 5.0%, and the consensus also puts the Fed’s preferred gauge of PCE at 3.8% that quarter.

DB have these two at a notably higher 6.9% and 5.7% respectively. Regardless of the inflation measure you use, it would imply that even when futures expect the Fed to stop hiking in nominal terms, the spot real rate is still negative.

That would be very significant if realised, since in the last 70 years of hiking cycles, the Fed has never conducted a hiking cycle in which their policy rate didn’t move above the rate of inflation at some point during the hikes, ie. achieving a positive real rate.

There’s an outlier argument that inflation will cool much quicker than the consensus expects, but it relies on a US economic hard landing. As things stand, hiking investors seem to be expecting the second-highest inflation rate since WW2 to be sufficiently tamed by a cycle that’s in recent times in its dovishness. Good luck everyone.

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