Central banks have been raising rates all year in an attempt to tame inflation. But with the fear of recession growing, will the Federal Reserve temper its commitment to push rates even higher? Kim Parlee speaks with Priya Misra, Head of Global Rates Strategy, TD Securities.
- We are seeing some very big moves in the market, daily moves right now when it comes to US rates. Can you put in perspective just how historic this is? When's the last time we saw this?
- So you're right. We're seeing significant volatility. One of the ways we measure it is, how many days are we seeing more than one standard deviation moves? And I would say this is the largest year in all the data we've been tracking. More than 50% of days this year have seen more than one standard deviation daily moves. The only other year that comes close was 2008, when you had the Lehman bankruptcy and the housing crisis.
So significant volatility. I think it's driven by uncertainty on the economic outlook. You talked about inflation, growth. I think they're really wide outcomes when people think about both these issues, as well as how the Fed responds to it. I think there's also question marks around that. And the market is less liquid, and there's less conviction, which is why I think we are whipsawing a lot in terms of rates.
- Well, maybe you could take us through what you're seeing. You've got this tug of war, which is, to your point, leading these very largely different outcomes that could happen. On the one hand, huge inflation; on the other hand, maybe very little inflation if the economy tanks. So what are you watching to see what's actually going to be true?
- Sure. So I think here's the issue. Growth is slowing. There's no question about it. And that is what the Fed wants. They're telling us they're tightening policy to slow growth. I think the question is, is it slowing below potential?
So far, the data that we have-- and we've had one negative GDP quarter. This quarter might also be negative, but that's not a recession. We look at the labor market. It's still strong. Consumer spending is slowing, but we're not in recession territory. So we're looking at high frequency metrics of growth to see growth is heading towards recession or is it slowing just a little bit below potential.
And then on inflation, I know commodity prices have come off, oil prices have declined. But there are other persistent measures of inflation, housing being one of them, that is a lagged variable. So we think housing inflation stays high. Service inflation ex-housing is also high. So we're looking at high frequency measures of both inflation and growth to see, does this derail the Fed path.
And what we're hearing, and we saw this in the Fed minutes today, is they are unconditionally committed to inflation. So I think the market has swung a little bit too much in concerns of recession and, therefore, expecting the Fed not to hike as much. I think they're going to hike 75 in July, 50 basis points after that, a couple of hikes after that, getting close to 4%.
And then the market has priced in all these cuts very quickly. I think the Fed will have to be more patient. Because if inflation is still high, we think it's going to be in the 3%, 4% range even six months out. It's going to be very hard for them to cut rates. So I think this tug of war, as you called it, we'll have to live in this tug of war for quite some time, because growth is slowing and inflation is high. And the Fed is going to be constrained in terms of doing a whole lot to help growth.
- And it sounds like we should get ourselves used to the volatility that comes with that. You mentioned what the market is pricing in. And I know that the word "terminal rate" is something that we're getting into our vernacular now. That's not something we talked about a long time ago, at least not at cocktail parties, as I'm sure you did. But right now, I think we're seeing that the market is pricing in the terminal rate-- you said earlier closer to 3.5% versus 4%. And you think that might be light.
- I think so. Just a day ago, it was 3.25%. We had a very big move today after the minutes, because the minutes suggested that the Fed remains committed on inflation. And even though the Fed is looking for growth to slow down, they are not saying that would slow down their rate hikes.
So I think because the Fed is focused on inflation, and because inflation is uncomfortably high-- and, frankly, they've lost some credibility on inflation fighting. So I think they're going to keep going, we think closer to 4%, and then they can slow down or pause on the rate hike cycle. So I think the market, which was pricing in 4%, actually-- at the June Fed meeting, we were pricing in the terminal rate at 4%-- it declined a lot in the last two weeks as people got more concerned about growth.
But I keep reminding clients, there's still inflation. We may be concerned about growth, but don't forget that inflation is still very high and the Fed is very much aware of how high inflation is and how much it hurts the most vulnerable parts of the population, which is why I don't think they are going to waver. I think they continue hiking closer to 4% is where we think they'll stop. So that's our estimate of terminal rate.
- Yeah. I think people-- you're right-- are just beginning to feel a bit of the pain of inflation. What about QT, quantitative tightening? We've talked about this before-- do you see the Fed continuing with that right now? And is there anything that would cause them not to continue with it?
- So good question. The Fed has been remarkably quiet on QT. It is a policy that they're using to tighten. It's supposed to run in the background, but that doesn't mean it's not effective. It is tightening policy. Absolutely, it's tightening financial conditions. I think the minutes suggest that QT continues.
As long as they are raising rates and as long as rates are unchanged-- so at some point, they reach terminal rate, and then they leave it unchanged-- I think QT continues. The big question is if they ease policy-- let's say it's a couple of cuts as they project-- we have a little bit more in terms of cuts priced in for '24. Then the question becomes, how can they cut rates and do QT?
So there is a case to be made that as they are easing policy in 2024, they may stop QT. But they have been actually very quiet on this front. I think if you look at the dot plot, they have only two cuts penciled in. At that point, maybe they do continue with QT.
If you're only taking rates from 3.8% to 3.4%, as the dot plot projects, you can continue QT, which will continue that tightening of financial conditions. But my fear is that growth slows down a little more. And so we actually expect them to cut about 100 basis points, getting close to maybe below neutral.
So we're actually looking for QT to most likely end by the end of next year. But it remains a function, really, of inflation, and growth, and everything that we're dealing with. This question has not really been answered by the Fed so far.
- Priya, always a pleasure. Thanks so much for joining us.
- Thanks for having me.