The Fed vs the markets - an epic battle for 2023

The fact we see 58bp of cuts priced into rates markets for the 2H23 offer me that confidence - so while Jay Powell will bang a message of higher for longer, if the rates market truly bought what he was selling we’d have not seen increased rate cuts priced and rate cut expectations would have come in, perhaps closer to 40bp.

The economic projections were clearly hawkish – the USD was right to spike (equity lower) on what we saw. The November CPI print had clearly driven market expectations that the 2023 fed funds projection (or ‘dot’) would be closer to 4.9% than 5.1%, so 5.1% was a surprise to the market. What’s more, 17/19 Fed voters projected a fed funds rate above 5% by end-2023. The rates market, as I say, doesn’t share this view.

We can look at growth expectations and see the Fed is forecasting just 0.5% GDP in 2023, a level below consensus, and certainly doesn’t offer much cushion for a soft landing, especially with unemployment expected to push up 90bp to 4.6%.

We can look at the inflation forecasts and see core PCE for end-2023 revised 40bp higher to 3.5% - it’s not overly positive that their models see inflation so sticky despite a far higher funds rate and weaker labour market – we can also adjust the Fed’s fed fund projection for their projections for inflation and see a real fed fund rate of 1.6% - that is undeniably hawkish.

Powell’s presser was predictably hawkish – the Fed chair made a strong case for not prematurely celebrating the evolution in inflation, but did welcome the progress, albeit stipulating it will take “substantially more evidence to give confidence that inflation is on a sustained downwards path”.

He played down the degree of cuts that are being forecast in the dot plot for 2024, suggesting they wouldn’t ideally cut until they saw 2% inflation. However, the market wanted to hear what it wanted to hear, and they wanted to hear the Fed were open to taking the pace to 25bp increments – we loosely heard that, and the Fed is open to a further slower pace (25bp hikes) and “feeling our way” towards a sufficiently restrictive territory.

In essence, the market is still of the view that inflation heads towards target in 2023 – economics and falling inflation will deteriorate sufficiently that Powell will be forced to cut earlier than he is stipulating – the likely result in a potential standoff between the Fed and the markets is volatility and the market forcing attempting to force the Fed to share the same vision as it sees.

We look at pricing around the 1 Feb FOMC meeting and see 32bp of hikes priced for this meeting – so, a near 30% chance of a 50bp hike, but that depends on the data flow – US non-farm payrolls (7 Jan) and CPI (13 Jan) jump out as influencing that call, but a 25bp hike seems the more likely outcome.

Let’s not forget that so often the reaction in markets on the day of the FOMC meeting is different from what we see the following session – often when positioning has been triggered on the facts, and calmer heads prevail the reaction can change – the ECB, BoE and SNB meetings in the session ahead do make that view somewhat more troublesome, but at this juncture I see breakouts in USDCHF, EURUSD, GBPUSD, AUDUSD and XAGUSD – let's see if the trend remains a friend.