PHOTO ILLUSTRATION BY CAM POLLACK/THE WALL STREET JOURNAL; ISTOCK (2)
Wall Street is making a game plan for a fed-funds rate that some think could hit 6%, the highest since 2000
Investors are bracing for the possibility that a second year of stubborn inflation could force the Federal Reserve to bring interest rates higher than they have been in more than 20 years.
Wall Street pros spent much of this year betting that the Fed’s already aggressive rate moves would quickly cool the economy and stem rising prices. But last week’s better-than-expected jobs report was the latest sign of economic strength to catch investors off guard.
Now, more are seriously considering whether the central bank’s target rate will rise as high as 6% before Fed officials take their foot off the brake—a level not reached since just before the dot-com bust in 2000, and one that could spell far more pain ahead for stocks and bonds.
“It’s really hard to see any progress on inflation in the next four or five months. Not enough to satisfy the Fed,” said Jim Vogel, manager of interest-rate strategies at FHN Financial. Mr. Vogel believes rates will get to 6% before the Fed is convinced that inflation has been tamed.
For now, most traders disagree. The Fed has already raised interest rates to up to 4% this year, from zero in January. Traders are betting the most likely outcome is that only a few more increases—to about 5% or 5.25%—will be enough to corral inflation.
But the prospect that inflation could linger is weighing even on more optimistic investors.
Jay Hatfield, chief executive of Infrastructure Capital Advisors, said he thinks inflation will slow markedly in the first quarter of 2023. Even so, his hedge fund has limited the scale of its bets that stocks will rise, fearing that persistent inflation could prompt more Fed action.
“You don’t want to get too bulled up right now, because at any moment in time, some Fed speaker can go out there and spout their bear case,” he said.
Thursday’s release of October inflation data will help shape investors’ views of how aggressively the Fed will act at coming meetings. Economists surveyed by The Wall Street Journal are expecting a 7.9% annual inflation rate, and a 0.5% month-over-month rise excluding food and energy prices. If the actual figures are higher, it will likely fuel greater concerns that 6% rates are on the way.
That scenario could bring more suffering to a range of investments, from long-term government bonds to hard-driving technology stocks, because high interest rates crush investors’ willingness to wait for payoffs they expect in the future. A long string of further rate increases could extend the market’s 2022 woes, including this year’s 20% decline in the S&P 500 and a historic downturn in the bond market.
Investors also worry that 6% rates could send the economy into a deep and lasting recession, with rising unemployment and a long road to recovery.
“It would get pretty ugly,” said Morten Olsen, a portfolio manager at Northern Trust. He and his team think the odds are roughly 1 in 5 that the Fed will need to raise rates to 6.5% or more before inflation falls to levels central bankers can stomach. If that happens, economic output could shrink every quarter for a year and a half, Mr. Olsen projected.
Month after month this year, inflation and employment figures have shown an economy that refuses to cool off as fast as the Fed would like. In the past few weeks, more traders have been taking seriously the prospect that sustained above-target inflation will stick into 2023.
Bets in derivatives markets show that traders believe the consumer-price index will rise by about 3.3% over the next 12 months. At the end of September, expectations were for 2.3% inflation going forward, close to the Fed’s target. Through September, the actual annual inflation rate stood at 8.2%.
Meanwhile, the Fed itself has quickly raised its own projections for how high rates will go. In June, most Fed officials projected rates would end 2023 below 4%. By September, most were forecasting the end-of-2023 fed-funds rate would top 4.5%. Last week, Fed Chairman Jerome Powell told reporters that rates would probably wind up even higher than recent projections.
That drumbeat makes a 6% fed-funds rate feel more plausible, said Brett Wander, chief investment officer for fixed income at Schwab Asset Management.
“Five percent has become the new 4%, and that could mean that 6% becomes the new 5%,” he said.
Rising rates have rippled through markets this year, driving a rout in bonds that has sent the 10-year Treasury yield to 4.125% at Tuesday’s close, up from 1.496% at the end of 2021. Yields rise when bond prices fall. That climb has undercut stocks, especially highflying technology shares, because rising yields on ultrasafe government debt offer investors an appealing alternative to riskier stock bets that might pay off far into the future. The tech-focused Nasdaq Composite has lost 32% this year.
Tighter financial conditions have also chilled capital markets, drastically slowing corporate fundraising via sales of new stocks and bonds.
A 6% interest-rate target from the Fed could pull the 10-year Treasury yield higher still, up to 4.6%, said Thanos Bardas, global co-head of investment-grade fixed income at Neuberger Berman. It is a scenario his team has thought through but considers unlikely, because they believe inflation will fall significantly before rates get that high, Mr. Bardas said.
Other investors also doubt that the fed-funds rate will hit 6%. If inflation remains stubborn, the Fed is more likely to respond by bringing rates somewhere above 5% and holding them there, said Matt Toms, global chief investment officer at Voya Investment Management.
Ten-year yields, adjusted for inflation, have already risen to 1.637% this year, up from minus 1.108% at the end of 2021. If the Fed raises rates much past 5%, so-called real yields would climb so much that economic activity could abruptly crater, Mr. Toms said. “Watching that real rate makes us think you don’t see a lot more upside in the fed-funds rate,” he said.
But Mr. Vogel argues that controlling inflation will require the Fed to continue to surprise investors by tightening monetary policy more than market-based forecasts now project.
“The Fed needs to stay ahead of where the market is,” he said.
Featured article licensed from The Wall Street Journal.