Fed expectations don’t add up in debt market

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Something is not quite right in the debt markets. Traders are betting that the Federal Reserve will raise interest rates seven times over the next 12 months, starting this week. That makes sense given the rate of inflation, which, according to the latest consumer price index of 7.9%, is the highest since 1982. But here’s the part that doesn’t make sense: many investors seem convinced that the United States can avoid a recession. despite the expected magnitude of monetary tightening and the slowing of the economy by soaring food and energy prices.

The news over the past week has again been dominated by images of Russia’s invasion of Ukraine. The conflict has caused a humanitarian crisis in Eastern Europe. Many are worried about food shortages in Africa and other countries that depend on the production of wheat and other grains from the region. The United States, United Kingdom and other countries have stopped buying Russian petroleum products, pushing up the price of crude and energy prices.

Almost all commodities have become very expensive in a short time. The Bloomberg Commodity Spot Index is up 27% this year. West Texas Intermediate crude hit $130.50 a barrel on May 7 before ending the week at $109.33. World food prices have hit a record high, according to the United Nations, and are likely even higher. Wheat prices have risen about 44% this year, while corn and soybeans have jumped more than 25%. Consumers are finding it harder to keep up, with wage increases falling short of rising inflation rates.

So how are central banks reacting? When the war in Ukraine started, rate negotiators felt that policymakers might not tighten policy as much as originally expected. But they’ve abandoned those notions, especially after the European Central Bank struck a hawkish tone last week by saying it planned to end its pandemic-era bond-buying program early. The message from central bankers is that they are more concerned with repeating their mistakes of the 1970s and letting inflation fester than with torpedoing the economy.

Yields on 2-year U.S. Treasuries climbed to nearly 1.75% on Friday, the highest since 2019 and reversing declines seen in late February and early March. Inflation expectations as measured by the bond market over the next two, five and ten years have reached their highest level in decades. The latest University of Michigan sentiment survey released on Friday showed U.S. consumers expect inflation to rise 5.4% over the next 12 months, the highest figure since 1981.

More and more analysts began to forecast a greater likelihood of the Fed raising its federal funds rate target beyond what they thought was likely in this economic cycle. Morgan Stanley is now seeing six 25 basis point rate increases this year, followed by four in 2023 to end this year at 2.625%, according to a research note released Friday by corporate economists led by Ellen Zentner. Bank of America Corp. strategist Savita Subramanian noted that her firm is still seeking seven rate increases this year, similar to before the war in Ukraine. “The important thing to remember is that seven rate hikes doesn’t even get us to a neutral rate,” she said in an interview with Bloomberg TV last week. “We are still at a super low level, relatively accommodating for short rates.” Even Treasury Secretary Janet Yellen changed her tune, expecting “very uncomfortably high” inflation to persist for at least next year. Just a few months ago, it was still calling rapid price increases transient.

And yet, despite the expected actions of the Fed, the yield curve, as seen in the spread between 2-year and 10-year Treasury rates, has narrowed but not inverted, which would be a sure sign for traders that they are expecting a recession. This may be because the outflow of credit appears to be under control, linked more to the prospect of higher interest rates than to a rapid deterioration in the credit quality of borrowers. Investment rate corporate bonds have lost nearly 8% this year, outpacing the 5.6% drop in junk bonds, according to Bloomberg Bond Indices.

Many investors believe that six or seven rate hikes in 2022 have been fully priced into the markets. This may be the case when it’s just a question of how much higher the rates will be. But that ignores the likelihood that Fed policy will actually work to rein in lending and slow business activity, which is one of the main transmission mechanisms of monetary policy.

Three results seem plausible. The first is that the Fed will raise rates fewer times than the consensus expects as inflation slows. The second is that the Fed will raise rates as much as expected, but the measures will not deteriorate financial conditions more than they already have, which will raise questions about whether monetary tightening is even effective in limiting inflation. The third is that the Fed is going up six or seven times this year, the yield curve is inverting, and traders of all types are preparing for a recession.

Given the double whammy of a Fed-induced economic slowdown coupled with stagflationary headwinds, it’s hard to see how selling off riskier stocks can remain as shallow as it has been.

More other writers at Bloomberg Opinion:

• Take-it-or-leave-it gas prices may be our future: Justin Fox

• What will be the impact of inflation in Ukraine? : John Authers

• The Federal Reserve must delay its rate hikes: Karl Smith

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Lisa Abramowicz is co-host of “Bloomberg Surveillance” on Bloomberg TV.

More stories like this are available at bloomberg.com/opinion

Tana T. Thorsen