Market’s Message To Fed: ‘Even One Hike Was A Mistake’

There’s a “fundamental disagreement” between the Fed and markets, and it can’t persist forever.

That’s the message from Deutsche Bank’s Aleksandar Kocic who, in his latest, pointed to a total and, more importantly, very early, collapse in the spread between neutral and terminal rate proxies.

Near the end of the last three cycles, the Fed typically hiked an additional 75bps after the rates converged (figure below).

So, conceptually, the Fed overshot each time. Once the two rates converge, that should be it, according to the market. If the spread is negative and the Fed keeps hiking, one can intuit a policy mistake unless there’s a rationale for pushing the envelope.

As figure shows, the spread collapsed to zero prior to the first hike this year, and then turned negative shortly thereafter. If every rate hike delivered following the convergence of terminal and neutral is a policy mistake, then, as Kocic wrote, “it appears the curve is saying that even one hike was a misstep.”

And therein lies the disagreement between the Fed and markets. Plainly, the Fed doesn’t agree that one hike was a policy mistake. That’s the stuff of policymaker nightmares, and it’d better not be true. Because following Friday’s hot payrolls print, swaps were pricing 200bps of additional rate hikes through the December FOMC meeting. If 25bps was a misstep, then what are we to say about 275bps?

Above, I offered a qualifier: “…unless there’s a rationale for pushing the envelope.” There is such a rationale this cycle. It’s 8% annual inflation. Fed officials have gone out of their way to emphasize a willingness to push rates beyond neutral to bring inflation down if necessary. But, as Kocic went on to say, “the problem with the current curve shape is not so much the pricing as it is its timing — the conflict of horizons.”

Prior to the first hike, analysts and market participants periodically pointed to apparent aberrations in rates as evidence that this hiking cycle was over before it started. The premature collapse in the terminal/neutral spread could be viewed as a thumbs down from the market on rate hikes, and because rates were at the lower-bound when the two converged, the implication is that the market is no longer willing to countenance rates that aren’t zero.

Kocic spelled that out in more eloquent terms. “It was an ex-ante verdict on Fed tightening as a policy misstep,” he said, calling this “an expression of markets’ (unconditional) intolerance of withdrawal of accommodation and non-zero rates, a sentiment that continues to be confirmed in everyday market dynamics: High intraday volatility, lack of commitment in either direction, and generally negative treatment of good economic news.”