Don’t Fight the Fed

Get our take on the latest Fed meeting.

One of the most well-known investment edicts is “don’t fight the Fed.” This obviously means that one shouldn’t bet against the current direction of monetary policy. If the Fed is tightening, then do the prudent thing and don’t pile into risk assets, for example.

I mention this old investing maxim because markets seem to have forgotten it. Risky assets performed well in the fourth quarter of 2022 (December notwithstanding) and have started 2023 strong. But we’re just not sure that jibes with the current path of monetary policy.

Powell Versus Participants

Essentially, Fed Chair Jerome Powell has been saying that rates are going to be higher for longer. But market participants, as evidenced by Fed funds futures, are expecting a pause in Fed rate hikes and pivot to looser monetary policy at some point in 2023.

In contrast, the Fed’s own so-called “Dot-Plot” projection for future rates shows no pivot before 2024. Both measures also show a disconnect in the projected final level of interest rates, with the market below the Fed’s own estimate.

Will the Fed Cave on Its Monetary Policy Plans?

The way I see it is that the market is betting that the Fed will have to cave in sooner in deference to the onset of recession or political pressure. And we believe that’s the crux of the problem. The market appears to be hyper focused on the near term, while the Fed seems intent on snuffing out any signs of inflation for the long term.

This view is supported by several recent Federal Open Market Committee (FOMC) communications. In the minutes from December FOMC meeting, Fed policymakers cautioned against underestimating their resolve to keep interest rates high for some time in what was an unusually blunt warning to investors.

To summarize, there is remarkable consensus within the FOMC itself that the peak funds rate will be above 5% and that there will be no cuts this year given their intention to bring inflation back down toward their 2% target. Yet, the market sees a peak rate about 25 basis points (bps) lower than the Fed and is pricing in a couple of cuts in 2023.

Next FOMC Meeting Is February 1

We’ll get some insight into how this tug of war is likely to play out at the FOMC meeting on February 1. Currently, Fed funds futures are pricing in a greater likelihood of a 25-basis point hike, rather than a 50-basis point hike at the previous meeting.

Hiking by 50 basis points would definitely send yet another clear message to market participants not to try to call the Fed’s bluff. But even a 25-basis point hike wouldn’t necessarily signal a pause or imminent pivot in monetary policy.

The punchline is that we believe there's a high likelihood that rates will stay higher for longer than the market expects.