That of the Federal Reserve flow rate hike policy aims at overcoming excessive inflation. Wall Street’s future analysis anticipates the Fed’s success leading to lower, stable inflation and interest rates. Therefore, there is no clear disagreement between the Fed and Wall Street.
So, why are there reports of the two disagreeing? Because there are two sides to the view of Wall Street. One half agrees and the other half disagrees.
The two halves of Wall Street
First, there are the professionals who are mainly focused on interest rates and inflation: bankers, bond analysts and bond fund managers. They are more in line with the thinking and acting of the Fed, especially taking into account the risks of being mistaken about inflation. (Remember, fixed income is at the mercy of inflation and interest rate movements. A superficial or moderate recession is less of a concern and may even be welcomed.)
Second, there are the professionals who are mainly focused on economics and business growth: investment bankers, equity analysts and equity fund managers. Their focus is on the risks of the Fed squeezing too hard and triggering a recession. (Remember, when it comes to stocks, inflation often goes hand in hand with growth. That’s why these pros are fine with stable, subdued inflation rather than risking a recession to bring inflation down to 2%.)
The split is visible in these two articles from Friday (Jan. 13). The Wall Street Journal, although the terms “money managers” and “investors” are applied on both sides of Wall Street.
Front Page: “Markets, Fed Divided on Rate Forecasts”
“Many money managers are predicting that inflation has peaked and price pressures will ease so quickly that the Fed will reverse some of its rate hikes by the end of the year, as it did in 2019, just seven months after the last hike.
“Fed officials are hammering out a different message: This time it will be different because inflation is much higher.”
In the “Heard on the Street” section: “Inflation Investors Fight the Fed”
“So investors think that inflation will come down quickly – that policymakers will eventually raise interest rates by less than they think and, in fact, will cut interest rates by the end of the year. Policymakers are probably concerned that investor optimism about the interest rates could leak into the economy, prolonging the inflation battle.”
Is 2% inflation really expected by Wall Street? no
Futures prices are currently showing expectations of falling interest rates from the end of the year. Longer-term interest rates, however, are well above the 2% level. A good way to see what Wall Street foresees is to examine the zero-coupon bond yield curve. With no interest payments, each bond accrues interest over its term. By examining the compounding rate for two different terms, we can calculate the interest rate for a future interval.
The table below shows the December 31, 2022 zero-coupon bond yields for each year, 1 through 10 (2023-2032), along with the interval yields (future year). Note four items related to the interval returns (last column):
- Yields for Years 1 and 2 (2023-2024) are at the current Fed Federal Funds upper limit of 4.5%
- The return for year 3 (2025) is still relatively high at 3.9%
- Yields for years 4 and 5 (2026-2027) fall to 3.6%, then 3.5% (the lowest)
- Yields for years 6 through 10 (2028-2032) show a normal rising yield curve pattern of 3.5% to 4.1%
So even with interest rates falling recently, each future year’s yield is priced well above 2%. In other words, the fixed-income side of Wall Street is considering the risks of the Fed not succeeding quickly or completely – that is, they are considering a full picture of possible outcomes, not just the most likely ones.
From the first WSJ article above:
“Frankly, I’m not sure why the markets are so optimistic about inflation,” Mary Daly, chair of the San Francisco Fed, said after the Fed’s meeting last month. “I think they’re priced for perfection,” she said.
“Fed officials, Ms. Daly, don’t have the luxury of pricing for perfection…We have to imagine the risks to inflation.”
The bottom line is: don’t bet on a single outcome
The number and magnitude of uncertainties and risks in the markets are now abnormally high. This means that determining how to invest is extremely uncertain and risky. Equities are challenging today as the equity side of Wall Street focuses on the approaching Fed endgame, when luck and growth return.
The Fed warns that they are not that confident, so expect higher interest rates with an uncertain effect. In addition, the Fed operates primarily on the basis of observed outcomes rather than a favored forecast. In addition, the risk of being wrong and having to start over is unacceptable to the Fed.
So while “waiting for the dust to settle” is usually a losing strategy in investing, this time it seems appropriate. The possibility of further slowdown in growth and lower revenues and the income is high enough to at least keep some money for future opportunities. The same goes for long-term bonds. Why fix today’s interest rate when the Federal Reserve is talking about more rate hikes?
Becoming optimistic too quickly can lead to unhappiness, doubt and regret – emotions that make it difficult to decide what to do next.