iFlow > Short Thoughts
Published on Tuesdays, Short Thoughts offers perspectives on US funding markets, short-term Treasuries, bank reserves and deposits, and the Federal Reserve's policy and facilities.
John Velis, David Tam
Time to Read: 7 minutes
EXHIBIT #1: RATE EXPECTATIONS RATCHET HIGHER AFTER EACH FOMC MEETING
Source: BNY Markets, Bloomberg
As expected at last Wednesday’s meeting, the FOMC under Chair Kevin Warsh did not change the policy rate but did provide a set of marginally more hawkish projections for the federal funds rate at the end of 2026. Even so, one would be hard pressed to deny that the meeting produced plenty for markets to ponder. Although it wasn’t surprising that Warsh didn’t provide any forward guidance beyond the dots from the Summary of Economic Projections (SEP), it still marks a significant shift in how the Fed has conducted its public business over the past decade. Combined with explicit references to price stability and the FOMC’s commitment to bring inflation back to its 2% target, the meeting was interpreted hawkishly by the markets, and rate expectations have moved much higher since Wednesday.
Exhibit 1 shows the movements of the implied policy rate since just before the conflict with Iran commenced, with steady moves higher after each FOMC meeting since then. We also plot the curve on June 16, one day before last week’s meeting (faint blue line) as well as yesterday morning, June 22. Note the shift higher; markets now expect two rate hikes by next April, with the first currently priced for this year’s September meeting. After that, expected rates plateau and even come off slightly.
The dots, as we expected, did remove the single rate cut previously shown for the end of 2026, with nine of the 18 submissions indicating higher rates, moving the median up by one hike. Still, that means that half of the Committee do not see higher rates this year, indicating a straight split down the middle. Interestingly, for end-2027 and 2028, the SEP show rates coming down after this year, with neutral, or “longer term” fed funds remaining at 3.1%, well below the peak of around 4% seen in the current cycle. Notably – but given his distaste for forward guidance, not surprisingly – Warsh himself did not participate in the SEP exercise.
So why, then, was the meeting interpreted so hawkishly by the markets? In addition to the change in the SEP – which we would classify as only the mildest of surprises – the Fed reminded us that while it has a dual mandate, it only explicitly referenced delivering “price stability.” Warsh’s frequent return to price stability and the fact that inflation has been above target for five years in his otherwise restrained press conference apparently led the market to its hawkish conclusion.
We discuss our rates outlook below, but for now, we note that both the statement and the presser signal that the Fed views the economy as robust enough to put – via the dots – a rate hike on the agenda. In a relatively short paragraph, the Committee asserted that “[e]conomic activity is expanding at a solid pace despite elevated uncertainty that owes, in part, to the conflict in the Middle East. Productivity growth and capital investment are strong. Job gains have kept pace with the workforce, and the unemployment rate has changed little.” A healthy macroeconomy and persistently above target inflation are a recipe for tight policy, especially for a Fed that – as Warsh has indicated he desires – is laser-focused on price stability.
EXHIBIT #2: FIXED INCOME VOLATILITY NEAR POST-PANDEMIC LOWS, A FLOOR THAT MAY NOT HOLD
Source: BNY Markets, Bloomberg
Warsh clearly wishes to rein in all the communications, and his task force on this topic is likely the tool with which he’ll do it. Many commentators have warned that eliminating forward guidance and curtailing communications could push interest rate volatility higher. If the rates complex doesn’t have (or thinks it has) a good idea about the path of future policy, markets will be reactionary and not anticipatory, leading to more frequent repricing as economic data evolves through the cycle and unanticipated policy changes occur. Exhibit 2 shows that fixed income volatility is nearly at post-pandemic lows and given the change in policy expectations since the end of February, could rise from here – especially if the market must learn anew how to function with a much quieter Federal Reserve.
We are aware of a counterargument to this hypothesis, however. If the Warsh Fed, with renewed inflation-fighting credibility and a radically reduced word count, succeeds in reducing inflation without jawboning, and rates follow a more rules-based process, the long end of the U.S. curve could see less volatility, not more. Of course, this argument implies that the Fed is not credible at the moment and that the long end is volatile now. We reject that implication outright. As for the former conjecture, we’re not convinced that the Fed has lost credibility on inflation, especially if long-term inflation expectations are a reliable proxy for such credibility. Both survey and pricing data haven’t shown any signs of becoming unanchored. Indeed, market-based measures of inflation expectations – which matter for bond pricing – are quite well-behaved. Most of the increase in 10y yields have been due to higher expected real rates, a nod to tighter policy going forward and possibly a world in which the cost of capital rises with demand for capital spending.
EXHIBIT #3: TAYLOR RULE HAS BEEN CALLING FOR HIGHER RATES SINCE 2021
Source: BNY Markets, Bloomberg, Bureau of Economic Analysis, Federal Reserve Board of Governors, Bureau of Labor Statistics
The biggest concrete and immediate change from the June FOMC meeting is, of course, in the rates market. After the meeting, the 2s10s yield slope fell from around 40bp (it had been as high as 70bp before the war) to around 20bp, a significant bear flattening from the front end; the 2y yield is now up to 4.23% from just 4.06% before the meeting. Two rate hikes by March 2027 are now expected, and the neutral, long-term rate – from a variety of proxy sources – is hovering around 4%.
A standard Taylor Rule model, which uses the current deviation of inflation and unemployment from their assumed equilibrium (or in the case of inflation, the Fed’s proclaimed target of 2%) to generate an estimate of the appropriate policy rate currently suggests that the funds rate should be 4.8%. Looking at Exhibit 3, the Taylor Rule indicated that the policy rate should have been as high as 9.8% in late 2022 with inflation raging and the labor market tight. We don’t believe that the current 3.75% target rate is a full percentage point too low, and we doubt anyone in the market does as well. However, the Taylor Rule estimate underscores that inflation has been persistently too high, and it must fall significantly to square the rules-based rate with the actual policy rate.
We haven’t moved our own rate call, which continues to see no change in policy rates by year-end. Of course, our view – as well as that of the market – is dependent upon the evolution of inflation and aggregate demand, with the labor market a key variable given its improvement over the last three NFP prints. A deteriorating labor market had guided our pre-war forecast of three cuts by year end; we trimmed that to two cuts in the early days of the conflict. But with the jobs story looking much better than we feared several months ago, and inflation still sticky, we obviously have changed our view.
Why don’t we agree with the market that rates are going higher? Put simply, there is still a lot to be revealed about the current macroeconomic environment. With the conflict having receded for now, we expect headline inflation to retreat – we just aren’t sure how fast and whether or not non-fuel, non-tariff related services inflation relents. The economy is reporting promising aggregate demand data, including consumption and investment. However, we are mindful of the knock-on effects of the conflict. A month or two of data will solidify our thinking and, if we need to change our view, it will be guided by the data as they evolve, and not by forward guidance from the Fed.
