A 'Not so Fast' Policy Reversal
The markets are writing checks the Fed, and the economy, are not going to be in a position to cash. Macro-driven investors are convinced the Fed is rapidly approaching the end of its tightening cycle. Once the peak in the funds rate has been established, these same macro-driven investors are also convinced that the Fed will be forced to reverse gears and begin to ease policy within a few months. Although the Fed is clearly much closer to the end of the tightening cycle than they were back in March, our view is that the peak in the funds rate is still many months away, and short-term rates are still expected to rise by an additional 150 basis points before a temporary peak is in place. Just because the Fed is expected to pause the tightening in late 2023 does not mean a fast policy reversal is also guaranteed or even likely. Specifically, we expect the Fed will slow down its tightening, and in the process, set the stage for both a higher peak and a longer restrictive policy stance.
A Resilient Inflation Cycle
A near-term peak and quick policy reversal scenario – currently being advanced by the macro investor community – is predicated on the credit crunch-induced recessions the economy has experienced over the past 30 years. The so-called second shoe to drop, which the bulls are anticipating, is not lurking just below the surface. In fact, our analysis submits the absence of any asset-liability mismatch and suggests the economy as a whole is less sensitive to rising short-term rates than at any other time in the post-war period. Without a pending credit cycle or a high degree of sensitivity to short-term rates, the economy and, therefore, the inflation cycle, will be more resilient than the bulls expect.
Credit Crunch Not Lurking
Despite our higher-for-longer Fed call, there are some conclusions with regard to the market that need to be highlighted. First, the belly of the Treasury curve – the 3-7-year portion – appears the most expensive segment of the Treasury market and therefore the most vulnerable to a correction. The 10-year benchmark may have topped out at 4.25% but we still see fair value at 4%, given our call that a credit crunch is not lurking, waiting to be triggered by a Fed rate hike. Our call on the spread equity market has been altered from a significant further sell off, to an extended 3,700-4,100 sideways trading range. Technically, the double bottom put in at 3,600 is likely to be hard to break, morphing our call into a sideways call. This implies the recent rally in bonds and equities creates a valuable new issue opportunity for corporate bond issues, but on a rate and a spread basis. Moreover, we are even more convinced today than we were a month ago that the dollar on a DXY basis peaked out at 115, and we believe 105 will set the bottom for the dollar going forward.