The market is more hawkish than the Fed

Last week, the ISM Manufacturing Index indicated the sector is expanding once again for the first time in 18 months — job openings increased to 8.76 million, continued jobless claims fell to their lowest level in nearly a year, and 303,000 jobs were added in March. All those statistics beat their respective market estimates.

As a result of the strong economic data, interest rates increased dramatically last week. Chairman Powell provided some relief to the market on Thursday when he indicated that recent inflation and economic data could be simply a bump in the progress towards sustainable, 2.00% inflation. He went on to state, “If the economy evolves broadly as we expect, most FOMC participants see it as likely to be appropriate to begin lowering the policy rate at some point this year.” The market viewed his comments as dovish, and the 10-year Treasury dropped by about five basis points after his speech. However, the strong non-farm payroll report on Friday sent the 10-year Treasury yield higher. The 10-year Treasury closed the week up 20 basis points at 4.402%, which was its highest level since mid-November.

The short end of the interest rate curve is now broadly in alignment with the FOMC. The market is now expecting about 62 basis points in rate cuts by the end of the year due to recent economic developments. For perspective, one month ago, the market was expecting an 88-basis-point cut by December, and two months ago, it was expecting a 113-basis-point cut by December. The dramatic revision by the market puts it broadly in alignment with the FOMC’s estimated three rates cuts. Now, the most interesting developments are on the farther ends of the interest rate curve.

The FOMC projects the Federal funds rate to be 3.10% in December 2026 and 2.60% over the long run. Although the “long run” timeframe is fairly undefined, for illustrative purposes, the graphic below averages the FOMC Summary of Economic Predictions over each year and then assumes the long-run rate is obtained over a five-year period. That is compared to the one-month Term SOFR forward curve, which can be used as a proxy for the market prediction of interest rates. Recently, the market is consistently over-predicting the averaged FOMC expected path of interest rates starting in June 2024.

Although the development may not seem particularly large, it is one of the first times in this rate-hiking cycle that the market seems dramatically more hawkish than the FOMC. For comparison, the market estimate versus the FOMC estimate as of April 5, 2023 is shown below.

The change has an outsized impact on swap rates. Using the curves above, in the current environment, a one-month Term SOFR swap rate over the eight-year period would demand roughly a 69-basis-point premium relative to the FOMC curve. A year ago, the one-month Term SOFR rate would have been at roughly a 39-basis-point discount relative to the FOMC curve.

It’s difficult to determine exactly why the change has occurred, but the most likely explanation is U.S. economic strength. In April 2023, roughly 65.00% of the market expected a recession to occur within the next year. Today, that figure stands at 35.00%. Looking to the years ahead, a recent boom in artificial intelligence, productivity gains, continued government spending, onshoring of supply chains, and increased immigration could all lead to a stronger economy for years to come. The strength could plausibly force the FOMC to keep the Federal funds rate elevated to ensure inflation remains in check.

Corporates should be aware of the recent shift in long-term expectations. The prospect of a Federal funds rate that never drops below 3.50% could impact borrowing costs, increase costs of capital, create considerations around equity versus debt funding, and potentially change consumer behavior in the foreseeable future.