federal reserve bank

The markets are now pricing in a 75-basis-point rate hike at Wednesday’s FOMC decision, something not seen since the Alan Greenspan days more than 27 years ago.

There is now a 93.5% chance that the Fed lifts the target rate to 1.5%-1.75%, according to CME FedWatch. 

Rate expectations have shifted drastically since the May CPI overshot forecasts. A half-point hike for June was fully priced in before the inflation numbers arrived premarket Friday. Now, more aggressive tightening is seen down the road.

“The policy rate at end 2022 implied by fed funds futures closed (Monday) at 3.72%, its highest to date by some margin, and implies just shy of +300bps of tightening over 5 meetings,” Deutsche Bank’s Jim Reid wrote. “Markets also moved to price in a terminal rate above 4% in the middle of next year, closer to DB’s call which has been the most aggressive on the street.”

“It’s perhaps an understatement to say the market will be hyper focused on how the Fed communicates the near-term path of policy at this week’s FOMC, especially including what size rate hikes they’re considering as adequate for the rest of the year.”

Goldman Sachs revised its forecast late Monday for hikes of 75 basis points in both June and July, citing hints in a Wall Street Journal article.

“This would quickly reset the level of the funds rate at 2.25-2.5%, the FOMC’s median estimate of the neutral rate. We then expect a 50bp hike in September and 25bp hikes in November and December, for an unchanged terminal rate of 3.25-3.5%,” chief economist Jan Hatzius wrote in a note.

Treasury yields have jumped and the 2s10s is close to inverting again this morning after a brief period in inversion territory early Monday.

The 10-year yield (TBT) (TLT) is down 7 basis points to 3.30%, while the 2-year yield (SHY) is flat at 3.28%.

An inversion is considered a signal of an upcoming U.S. recession, now the base case according to an FT survey of economists. Morgan Stanley CEO James Gorman put the odds at 50/50 yesterday.

Does the Fed care if stocks sink?

Along with the surge in yields and rate expectations, equities have tumbled. The S&P 500 (SP500) (NYSEARCA:SPY) fell back into bear market territory from January highs on Monday, while the Nasdaq 100 (NDX) (QQQ) shed another 4.6% and is off more than 30% year to date.

The bear market “label has no economic significance,” UBS chief economist Paul Donovan said. “Do equity losses matter economically? Less than might be thought. Barely half of US households own any equity.”

“Ownership is concentrated in higher income households which have savings stockpiles, limiting any negative ‘wealth effect’ on consumer spending,” he added. “More interesting is whether corporations change hiring or investment after equity moves.”

In a recent BofA client survey, a plurality believed a Fed Put, or move to bolster equity prices, would come into play at S&P 3,750, right where the market closed yesterday. 

Instead of a Fed Put, though, investors are looking at a hike of 75 basis points, or what TS Lombard recently described as the Central Bank Call.

Chance of a rally

While stocks would be expected to fall further on such a big rate hike, if 75 basis points is already priced in the damage may already have been done.

Indeed, an aggressive Fed in the summer could open the door to a pause later this year.

Larry McDonald, who write The Bear Traps Report, argued that since a decline in stocks tightens financial conditions, the Fed will have no choice but to pause if stocks tank

J.P. Morgan global strategist Marko Kolanovic, who has remained overweight on equities, said Monday that the Fed will follow through with its previous guidance of 50 basis points tomorrow.

We “believe rates market repricing went too far and the Fed will surprise dovishly relative to what is now priced into the curve,” Kolanovic wrote.

“The move in markets prices in more than enough recession risk, and we believe a near-term recession will ultimately be avoided thanks to consumer strength, COVID reopening/recovery, and policy stimulus in China.”

Photo by Joshua Woroniecki, Unsplash

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