What changes will the FED make to its monetary policy?

The Fed could lift rates to 5.5% and hold them there through the rest of the year.

>> The risks of central banks in data dependency

Through all of this, we have not adjusted our own forecasts. We still think that 4% is a decent yield for 10-year treasuries, and we still believe that the Fed will lift rates to 5.5% and hold them there through the rest of the year.

So why have we not followed the trend and lifted our US rate forecasts? The first reason is that our forecasts were on the high end of expectations in the first place, and hence many others—and the market—have caught up with our predictions. But more than this, we are reticent to jump on the back of what we might call ‘data surfing’ at the moment as the market and many analysts jump on the flow of firmer US data to lift rates and forecasts.

Now, clearly, this might seem like a dangerous thing to do. After all, the Fed has become super data  dependent, as we talked about yesterday, and with some data, such as payrolls and inflation, higher than expected recently, it would seem to make sense to increase forecasts for the Fed’s terminal rate and our forecasts for treasury yields. But we are wary of data surfing like this because, just like real surfing, you can easily fall off. This will undoubtedly happen if the data starts to underwhelm.

On this score, we do think that the numbers will deteriorate. On the economy too, we have resisted the trend amongst analysts to erase, or at least reduce, the possibility of a recession. We still think that a recession is most likely in 2023, and as data starts to turn down, indicating a recession and easing price pressure, treasury yields should fall and the Fed end its tightening cycle at a rate of 5.5%.

>> How does tightening policy impact the labor market?

In our view, there are a couple of areas where we have concerns about the economy. One of these relates to the tightness of the labor market. While there’s no doubt that the last payroll data was super-strong and that the unemployment rate is very low at 3.4%, signs continue to grow that this won’t last (whatever today’s labor market data show). For a start, data on layoffs continues to rise sharply, and while that does not seem to have satiated the high levels of job vacancies, we have little doubt that it will given time. We also feel that apparent labor hoarding by firms cannot be a permanent fixture in the economy. Sooner or later, firms will shed ‘excess’ labor, and this could come pretty thick and fast, particularly if demand in the economy slows.

Outside of the labor market, monetary trends bear watching. It is well known that broader measures of the money supply have started to show negative annual growth rates for the first time ever (-1.7% for M2 in January). Now, we have argued before that monetary conditions are not this tight given things like the outstanding stock of assets on the Fed’s balance sheet, but even if we take this into account, there’s a possibility here that this fall in monetary growth could be a harbinger of weaker nominal GDP; we just don’t know whether any weakness will fall on the side of growth or inflation. But whatever it is, it seems likely in our view to make the Fed pause its rate hikes and to lower treasury yields.

The bottom line is that, because we had originally set our rate forecasts at quite high levels and because we feel the economy will stall, we have not lifted our forecasts for the peak of the fed funds rate or the peak for long-term treasury yields. The former is still 5.5% and the latter 4% (for 10-year yields). Of course, we are not oblivious to the possibility that soaraway data like another 500k-plus payroll rise today will lift rates and, most probably, force us to hike our forecasts. But as long as the data comes through as anticipated, we might look back on the current situation in the future and suggest that the market got a bit carried away in its expectations for higher rates.