This is how high interest rates can rise and scare the Federal Reserve into a policy line


The stock market’s reaction to Thursday’s latest inflation report underscored just how confused and scared investors are.

S&P 500 SPX,
+2.60%
September’s Consumer Price Index fell to 3% shortly after opening as inflation showed accelerating. Stocks reversed course shortly before noon, and the benchmark index rose 2.6% on the day in one of the biggest reversals on record.

Nick Sargen, an economist at Fort Washington Investment Advisors with decades of experience at the U.S. Treasury, Federal Reserve and Wall Street banks, spoke with MarketWatch about his outlook for unexpectedly high inflation, peak interest rates and the biggest risk to financial markets. The interview has been edited for clarity and length.

MarketWatch: What did you think of this morning’s CPI numbers?

Sargen: I expected the number of titles to drop year by year. It didn’t go down as well as I and most other people expected. My expectation was that by the end of the year this figure would drop to 7%.

MarketWatch: This can still happen.

Sargen: It is possible, but have you filled the gas tank? Two weeks ago, the regular dropped to $3.15. I have now topped up at $3.59 due to the OPEC+ effect. What we had going for us was a huge price drop in petrol.

It’s the services component that people don’t appreciate, ie [showing unexpectedly high price increases]. From month to month, some measures, variable ones, have gone down, but the services component is going in the other direction. Part of them is the housing component.

As mortgage rates rise, housing prices should fall. But CPI measures the calculated rental rate. Core inflation will stay higher for longer – not just the house price effect, but the mortgage effect collides with the price effect. This works with a delay in the system.

MarketWatch: The Federal Open Market Committee has already raised the federal funds rate by 0.75% after each of the last three policy meetings, from the current 3.00% to 3.25%. What do you expect the FOMC to do after the November 1-2 meeting and through the end of the year?

Sargen: The market is confident that the Fed will raise interest rates by another 75 basis points on November 2. Now we are talking about December. Maybe they will lower it [an increase of] 50 [basis points] in December. I think they wanted to get it to 4.5% by the end of the year – that’s the icing on the cake.

MarketWatch: What peak federal funds rate do you expect this period?

Sargen: Maybe 5.5%.

MarketWatch: What will happen to the long end of the US Treasury yield curve if the federal funds rate hits 5.5%? [On Oct. 13, the yield on two-year U.S. Treasury bills
TMUBMUSD02Y,
4.471%
was 4.48%, while the yield on 10-year Treasury notes
TMUBMUSD10Y,
3.944%
was 3.96%. A “normal” yield curve means yields increase as maturities lengthen.]

Sargen: My guess is that the entire curve will shift upward, but more inverted than today. Now we have a slight inversion. Many people think that an inverted curve is one of the best early signs of a recession. The current curve shows that the market expects a weakening economy. The market is now pricing in a 4.5% federal funds rate.

MarketWatch: How about some of the views among money managers and the financial media that the Federal Reserve is moving too fast with interest rate hikes and bond portfolio declines?

Sargen: The Fed, in my opinion, was the main culprit of inflation because they kept rates too low for too long and continued to expand the balance sheet.

The Fed made a serious misjudgment about inflation last year. They attributed it all to supply chain disruptions and COVID. They said it was temporary. This was wrong. In September 2021, Federal Reserve Chairman Jerome Powell started talking about inflation taking longer than expected. He was clearly changing his tune. He was reappointed by President Biden in November. The big surprise was expected to raise interest rates and reduce bond purchases.

Because they wait so long, they have to play catch-up, and there’s always the risk of overdoing it.

MarketWatch: What could trigger a bond market crash in the US like we saw recently in the UK?

Sargen: You talk about financial instability. The biggest risk that none of us can see is the exposure of financial institutions and who is using them. It’s more frightening and could lead to the Fed stalling with a tightening cycle – if they take a breather, a major financial institution is in trouble.

This is an obvious lesson [the bond-price action in the U.K.]. The Bank of England is struggling with inflation and suddenly has to bail out pension funds. They are at cross purposes.

With Credit Suisse CS,
+6.59%,
we have a European institution. It is not systemic unless it creates effects on other entities. My point here is that US bank balance sheets are less leveraged than they were in 2007.

What could cause the Fed to stop tightening sooner would be some kind of concern about systemic financial risk.

MarketWatch: Could there be a liquidity crisis in the US?

Sargen: I don’t expect that in the US because we are the safe haven of the world. Everyone is talking about the stock market. But this is the worst bond market in the US [for year-to-date total returns] in history.

What is the best performing asset in the US? USD. It’s super powerful. Does everything look great here? No, but I will choose the US economy over the European or Japanese economies. China is no longer a locomotive. President Xi Jinping has done more damage to China’s economy than anyone since Mao.

So I don’t see any liquidity risk in the US, it would be outside the US

Don’t miss: The stock market is in trouble. This is because the bond market is ‘very close to crashing’.



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