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Market Update

FOMC will continue to raise the Fed Funds rate “until the job is done”

At his Jackson Hole speech, Federal Reserve Chair Powell said, “We will keep at it until the job is done.” In other words, the FOMC must continue to raise the Federal Funds rate and hold it at a restrictive level until it is confident inflation is under control. He specified that while the July CPI inflation reading was welcome news, it would not be enough on its own for the FOMC to change course on raising interest rates to an intentionally restrictive level. Powell recognized that continuing to raise rates will cause financial pain across the economy but argued that failing to restore price stability now would result in much greater financial pain in the future.

For their part, Federal Reserve presidents have been warning market participants that their rate expectations were too low for weeks.

  • On July 27, Chair Powell stated that the best prediction of the Fed Funds path is the June SEP, which suggests a 3.8% Fed Funds rate by the end of 2023.
  • On August 2, Fed President Daly said, “[The FOMC was] nowhere near almost done.” When asked if the market’s prediction that the FOMC would begin cutting rates by the middle of 2023, she responded by stating, “That’s a puzzle to me. I don’t know where they find that in the data. To me, that would not be my model outlook.”
  • On August 10, Fed President Kashkari said the Fed is “far away from declaring victory.” Both Fed presidents Kashkari and Evans stated on August 10 that the FOMC will need to increase the Fed Funds rate to 3.75% - 4.00% by the end of 2023, a 150 basis point hike from the current level.
  • On August 25, Fed President Bullard stated, “You have got to have a 3 handle. Right now, we are at 2.33%. That’s not high enough to be serious about putting downward pressure on inflation.” He went on to say that a likely outcome for 2023 will be that inflation is more persistent than many Wall Street analysts expect and that the risk of such an event was underpriced by Wall Street.

It is clear the Fed has been trying to guide markets to expect rates to remain elevated through 2023, and it appears Wall Street is finally starting to pay attention.

The graph above shows the market-expected Fed Funds rate based on CME futures data. After Chair Powell’s press conference following the July FOMC meeting, the market expected rates to rise to about 325 basis points by December 2022 and then steadily fall by July 2023. This is shown by the dark blue line, which represents the markets’ December 14, 2022 FOMC prediction, being higher than both the light blue and ruby lines, which represent the March 17, 2023 and July 28, 2023 lines respectively.

As a result of Fed commentary, the market has slowly shifted to expect higher rates for a longer period. Although the market is still expecting rates to fall moderately from March 2023 to July 2023, there is no longer a 25-50 basis point reduction expected between December 2022 and July 2023. Additionally, the market is starting to align with the SEP projections from the June FOMC meeting, which suggest a 340 basis point Fed Funds rate by December 2022 and a 380 basis point Fed funds rate by December 2023.

As a result of the market pricing in additional rate hikes relative to late July and a 3.50% - 3.75% Fed funds rate from December 2022 to July 2023, swap rates are up across all tenors over the past month.

Additionally, as the market expected path of U.S. interest rates continues to increase at a faster pace relative to other nations, the dollar has strengthened considerably over the past month as well.

For corporations with floating rate debt and exposure to foreign exchange rates, the potential downside risk in both environments is still very plausible. Although the market has adjusted its rate expectations upwards in the last month, signaling from Fed presidents suggests that a 4% Fed Funds rate is still well within reason over the next 6-12 months. Relative to current market expectations, that would represent an additional 25-50 basis point move upwards in rate expectations. If rate expectations continue to rise, the dollar would be expected to strengthen, swap rates would be expected to continue increasing, and floating rate debt payments would continue to increase.

Due to current market expectations, locking in a fixed rate swap today could also be advantageous for companies with poor short-term liquidity. If the inverted forward curve is correct, locking in a 7-year, 2.83% swap rate today would allow for a $121,300 cash pickup for each $10,000,000 in notional hedged over the next two years. Due to the present value calculation of swap rates, the short-term cash gain would then be repaid over the final five years of the swap. Nevertheless, for corporations with liquidity concerns today and an expectation of increased cash flow in the future, it could be a very useful strategy.

(Related insight: Read, "Recapping Powell’s Jackson Hole 2022 speech")

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About the author

  • Brandon Stitzel

    Analyst

    Corporates | Kennett Square, PA

    Brandon is a rotational analyst within the Global Corporates sector, working with organizations to develop and maintain risk management programs across the interest rate, foreign exchange, and commodities asset classes.

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