Investors doubt the Fed can rein in the worst inflation in four decades without pushing the economy into recession.
That’s bad news for Americans, who face the risk of a recession while paying higher prices for food, rent and fuel. But for bond investors who have suffered a bruising year, there may be light at the end of the tunnel. The latest MLIV Pulse survey suggests the recession will prompt the Federal Reserve to cut interest rates next year.
More than 60 per cent of the 1,343 respondents, including retail and professional investors, said the chances of the Fed controlling inflation without triggering an economic contraction were low or even zero.
Tracy Chen, portfolio manager at Brandywine Global Investment Management, said:
“Whether the Fed will succeed in tackling inflation is an open question because it is a very challenging task. I don’t think the Fed is going to ignore the rising risk of recession, but at the same time they are going to watch inflation. So I’m still bearish on Treasurys, but yields could be near the top as well.”
About two-thirds of MLIV Pulse respondents expect the 10-year Treasury yield to peak below 3.7 per cent in the next nine months. For bond bulls, the climb to the top may be a struggle, but the expected peak is not far from June’s peak of 3.5%, so overall losses may not be much worse than last month.
The 10-year Treasury yield roughly doubled from March to mid-June as financial markets quickly repriced this year as the Fed pulled back from its epideme-era stimulus. Through June 14, the Treasury composite index was down nearly 12%, more than triple its record decline in 2009, according to data going back to 1973.
But bond markets have since rebounded, with yields falling sharply on Friday after data showed US business activity contracted for the first time since 2020. Overall, Treasury yields have retreated in recent weeks on speculation that tighter financial conditions are slowing economic growth, which will eventually lead the Fed to stop tightening and continue to ease monetary policy next year. This view is mirrored in the MLIV survey, which found that most people think the Fed will start cutting rates in 2023.
Before that, most of the respondents on whether the fed will increase the rate increase is skeptical, though some speculation that the fed will be on July 27, the earliest policy-setting meeting to raise interest rates 100 basis points, whole but now most people expected, the federal reserve will keep the speed of each meeting raise interest rates by 75 basis points, in line with the rate increase in June.
Most respondents said the fed funds rate would peak at no more than 4 per cent, in line with the range of quarterly forecasts by Fed officials. Some 26% of investors thought it was more than 4%, and about 8% said it was 3%.
Still, investors expect inflation to remain high: more than 50 per cent of respondents believe the Fed’s interest rates will be below inflation when inflation peaks, suggesting that markets expect the Fed to tolerate higher-than-normal inflation rather than continue raising rates during a recession.
Aneta Markowska, chief U.S. economist at Jefferies LLC:
“The Fed will raise the funds rate to 4% in March, which will drag down gross domestic product by the second half of 2023 and push the economy into recession. At that point, inflation will still be close to 4 per cent, but the Fed will pause.”
Investors rushed to pricing according to the latest economic data, as well as the uncertainty of the fed’s policy path, exacerbated this year the Treasury market price fluctuation in the historic, make the situation worse is that some is not the fed’s control factors, such as supply chain bottleneck, Asia’s resistance to disease caused by policy and the conflict between Russia and Ukraine energy prices are soaring.
The survey doesn’t suggest the volatility will subside: nearly 20% of respondents think the 10-year yield will peak in the next nine months, with the lowest forecast at 2.9% and the highest at more than 4.1%. Mark Freeman, chief investment officer at Socorro Asset Management, said:
“The real question is how far market expectations deviate directly from reality. There is a growing consensus that inflation may have peaked, but the problem is that inflation is not rising in a straight line and the underlying inflation trend will continue until the Fed actually creates a less tight labor market.”