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Market Update

The market is fighting the Fed yet again

December 19, 2022


After inflation, retail sales, empire manufacturing, and the Philadelphia Fed business outlook all came in below estimates last week, the market — as evidenced by Treasuries and forward curves — broadly disagrees with the Fed’s interest rate outlook.

Lower inflation was the primary trigger of lower rates last week. Consumer price inflation was 7.1% on an annual basis in November, lower than the 7.3% estimate and the 7.7% inflation rate in October. Notably, month-over-month inflation for November was just 0.1%, driven by increases in food and shelter and a decline in energy. Retail sales fell 0.6% in November, significantly lower than the -0.2% estimate as consumers started reducing spending ahead of the holiday season.

Manufacturing data also provided fuel to the rates decline. The empire manufacturing index missed the -1.0 estimate by a very large margin; it was -11.2 points in December. Anything below zero suggests manufacturing conditions are worsening in New York State. For perspective, excluding August, the number has not been lower since May 2020. The Philadelphia Fed Business outlook was also below expectations of -10.0 and was reported at -13.8. The broad indicators were all negative in the report, and the new orders index hit its lowest point since April 2020.

Unsurprisingly, the market interpreted the news as a net negative for the overall economy. Ten-year treasury rates declined in tandem with swap rates across all tenors by the end of the week.

With most of the same news in mind, rather than lowering rate expectations, Fed officials instead unanimously agreed they expected rates to be higher than previously thought. The Fed’s new summary of economic projections and dot plot indicated that, on average, FOMC officials expected the fed funds rate to be 5.217% in December 2023.

The graph above shows both the FOMC and market expectation for the fed funds rate in December 2023 over time. Unlike in prior months, the market is broadly disagreeing with the Fed’s most recent rate projection. Based on CME futures, 97% of market participants believe the fed funds rate will be lower than the current December FOMC projections. Rather than the market increasing expectations after the summary of economic projection (SEP) release, as it has over the past few releases, the market rate expectation instead dropped.

Current CME futures data suggests the market believes the fed funds rate will be 432 basis points in December 2023. That figure is 90 basis points below the FOMC prediction. The differential is one of the largest of the year.

Using 1m Term SOFR as a proxy for the market’s anticipation of rates over the next five years, the market expects a lower terminal fed funds rate and interest rates to fall faster than the FOMC currently projects across the entire curve, excluding the “longer run”.

The deviation in market expectations as compared to the current FOMC projections could be due to several factors. Examples could include the market incorporating a greater recessionary risk, lower inflation expectations, a weaker U.S. economic condition, higher unemployment, or inflation receding faster than the FOMC members predict. History suggests, however, that the market routinely underpredicts both the pace of increases and the terminal fed funds rate during tightening cycles. If the Fed raises rates at or faster than its projections, as it did over the past 12 months, treasury and swap rates will increase.

For corporations, this means there is still a very real risk that interest rates will continue to rise across the curve both in the near term and in the long term. For corporations looking to reduce volatility in their interest rate risk, taking advantage of an optimistic market that is potentially underpredicting the path of rate increases could be beneficial if the Fed raises rates in line with or faster than its current projections. This could be accomplished with products such as swaps and caps.

For perspective, the last time market expectations were 85 basis points lower than the Fed’s projections was July 21, 2022. Over the next two months, the Fed went on a campaign to readjust market expectations and ultimately raised its projections again at the September FOMC meeting. Over that time period, swap rates increased by between 0.9% and 1.1% across 2-to-7-year tenors, as shown below.

There’s no way to know whether the market or the Fed is correct in its projections of the next four years of interest rates. However, it is clear the market is currently fighting the Fed on whether the federal funds rate will top 5%.

(Related insight: Read "A downshift in hikes but more to come in 2023")

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Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit