Where does it end?

That’s the question now for market participants warily (and wearily) eyeing the most aggressive Fed tightening cycle in a generation.

As Deutsche Bank’s Aleksandar Kocic wrote, in his latest, traders spent most of last year asking what the Fed was likely to do next, as policy struggled to catch up to accelerating inflation. “The uncertainty was concentrated around the frequency and intensity of short rate hikes [with] the anxiety reach[ing] its peak in June, when the market began to question the adequacy of 75bps increments,” he said.

Now, in 2023, it’s a question of destination. Late last year, when the Fed endeavored to play down the significance of smaller hike increments by emphasizing the “How high?” and “How long?” talking points, officials seemed to assume the “How high?” question wouldn’t be terribly difficult to answer. Or, at the least, that an answer (any answer) would reveal itself at some point in 2023.

Although terminal rate divination makes for the best headlines, the more difficult quandary was assumed to be discerning the length of time policy needed to stay restrictive in order to restrain demand such that price growth moderated to the desired level. Two months into the new year, though, “How high?” is proving to be an especially tricky question. We can’t focus on “How long?” yet, because it’s not relevant until we know “How high?”

A spate of unexpectedly hot data (and revisions which largely wiped away the perception of meaningful disinflationary momentum in Q4) raised the specter that the long run neutral rate might be higher, and that, in turn, could mean policy isn’t yet restrictive. In a “worst” case, policy might not be restrictive at all yet, and because we’re dealing with unobservable rates and nebulous concepts, there’s no way to say for sure.

“Persistently high inflation (and encouraging growth) numbers continue to suggest a need for extension of the tightening cycle beyond what the market was pricing only a month ago, alluding to a higher neutral rate,” Kocic went on. The evolution of the Fed narrative is reflected in the vol surface, as illustrated below.

Once the 100bps speculation subsided, uncertainty shifted away from front end. Notwithstanding the burgeoning debate about a potential re-escalation from the Fed to at least one more half-point move, most of the ambiguity going forward will center on the destination for policy and, assuming that question is eventually answered, how to long to hold terminal.

But, as alluded to above, the stakes (which were already quite high) have been raised over the past month. “In the context of rising inflation and the relatively minor ability of rate hikes so far to meaningfully alter its trajectory [the focus on the destination for policy] reflects a higher-order uncertainty as it tackles the effectiveness of monetary policy and potentially Fed credibility, which can have non-trivial long-term consequences that extend far beyond the current cycle,” Kocic wrote, in the same note.

At this point, having repeatedly insisted that no change to the inflation target is under consideration this cycle, the Fed has little choice (no choice, really) but to keep at it until either inflation gets back down near 2% or the length of time spent materially above 2% despite ongoing rate hikes forces the Fed to concede defeat.

“Given the stakes involved, our view is that rates are positioned to move higher with the belly leading the way, reflecting the higher risk premium and the need to raise the terminal rate,” Kocic said.

From a trade perspective, that means focusing on five-year tenors, but for more general audiences, the more important takeaway is the connection between the quest to discover “sufficiently restrictive” and r-star. I explored that nexus in an article published here+ last weekend. Kocic drove it home in his latest.

“In the near- to medium-term, we expect to see a manifold repricing of rates along the lines of accommodating a higher terminal rate,” he wrote. “And we believe the terminal rate will lead the way as the first stage of price discovery towards the true neutral rate.”

Hopefully, we won’t look up a year from now and find ourselves asking the same question posed here at the outset, only without the word “where.”