No November hike, but atypical USTs, consumer habits muddy December picture

Analysts are certain the Federal Open Market Committee will not increase rates at the meeting that ends Wednesday, but the December meeting is still in play for the last 25 basis point rate hike that was predicted by the panel’s Summary of Economic Projections.

The final 2023 meeting remains in play, according to Tony Welch, CIO at SignatureFD. “They could go in December, but there’s been enough alleviation in inflation they could hold pat,” he said. “The longer end of the curve is doing part of their job, but the market is underpricing the possibility of a December hike. It’s a coin flip.”

The bond market’s reaction to this hiking cycle, however, is historic, according to John Hancock Investment Management Co-Chief Investment Strategist Matt Miskin.

This could be the first time the bond market has posted three consecutive negative total return years, he said. Additionally, should July prove to be the end of the cycle, the 10-year Treasury yield will have risen after the final hike, Miskin said. “Usually when the Fed funds rate peaks, the 10-year yield has already peaked.”

The other anomaly in this cycle: “after a yield curve inversion, it is rare to see a bear steepening occur (longer-dated yields rise more than shorter-dated yields),” Miskin said. “Usually a bull steepener happens next, as yield curve inversions, typically the next move for the Fed is to cut rates.”

Economic strength, seen in the 4.9% gain in gross domestic product in the third quarter, suggests the rate hikes are being absorbed, according to Welch.

Overall, the inflation picture is improving, although still higher than the Fed’s target, Welch said. Friday’s consumption report showed a year-over-year inflation slowed from the previous month, he noted. “That’s what the Fed is looking for,” a downward trend, with one month’s number not critical. “It’s a little hot, but in context we’re seeing improvement,” Welch said.

Still the Fed’s 11 rate hikes haven’t entirely worked through the economy yet, he said, explaining “There was a misunderstanding of how insulated consumers and companies were” from higher interest levels.

The mixed UST picture and consumer habits aside, for now, Welch doesn’t expect an impending recession, and it’s “too soon” to determine if there will be one before the end of 2024. He pointed to the 1.5 job openings per person looking for a job. “Until that’s worked off there won’t be a recession.”

Gary Pzegeo, head of fixed income at CIBC Private Wealth U.S., agreed there won’t be a rate change, but the Fed will keep the possibility open for December.

“Financial markets have tightened since the Fed’s last meeting — long-term rates are higher; equity prices are lower — and that would normally give the Fed cover to back away from tighter monetary policy,” he noted.

Inflation remains sticky, noted ING Chief International Economist James Knightley. “Intensifying concerns are now coming to the fore over the path for real household disposable income — the key driver of consumer spending. Unless this turns around rapidly, recession will start to look more likely, and inflation will fall more rapidly than the Federal Reserve expects.”

BMO suspects “a prolonged pause could be unfolding,” noted Deputy Chief Economist Michael Gregory, who said it’s too soon to say rates won’t be raised in December or January, since “on-the-ground economic data still display resiliency and inflation figures still flaunt underlying stickiness.”

Had the Fed not suggested it would skip at this meeting, Gregory said, “the market would probably be pricing higher than 6% odds of a rate hike.”

The 4.9% growth in GDP suggests the below-trend growth the Fed says is needed to restore price stability has yet to arrive, he added.

“Meanwhile, the Fed’s new fav underlying inflation gauge, the core services ex-housing or ‘supercore’ PCE price index, rose 0.4% in September after inching up 0.1% in August,” Gregory noted. While the annual number fell 0.1-point, “the three-month trend accelerated to 4.0% annualized from 3.2% before,” he said. “The 4% range seems sticky.”

Unless these data “weaken meaningfully, and very soon,” additional tightening remains possible, he said.

Still, Gregory said, “For the record, we’re expecting the economic indicators to weaken meaningfully in the month or two ahead, sufficient to forestall further rate rises. Amid the lagged impact of policy rate hikes along with dwindling excess savings and tightening credit conditions, we reckon the headwinds from higher bond yields, the resumption of student loan payments and the autoworkers’ strike (the Ford agreement aside) should do the trick.”

The GDP report “shouldn’t dissuade the Fed from leaving rates unchanged,” said Ryan Swift, U.S. bond strategist at BCA Research. “First, FOMC participants were already comfortable signaling a hold at the November meeting in recent speeches, despite widespread expectations that Q3 growth would come in hot.”

Second, he added, core PCE remains “consistent with inflation coming in well below the Fed’s forecast for the year. Specifically, we calculate that monthly core PCE inflation would have to average 0.35% for the next three months to hit the Fed’s 3.7% median forecast for 2023,”

If economic activity fails to “downshift” in this quarter, Swift said, further rate increases are possible, although BCA believes the “tightening cycle is over, with the caveat that another rate hike in December is possible if Q4 real GDP growth is tracking above 3% at the time of the December FOMC meeting.”

But consumer spending data “is likely to give members of the Federal Reserve angst as they continue to fight stubborn inflation, driven, in part, by strong shopping,” according to José Torres, Senior Economist at Interactive Brokers. The latest core PCE price index accelerated “significantly” from August.

Bryce Doty, senior vice president and senior portfolio manager at Sit Investment Associates calls Fed Chair Jerome Powell’s assertion that rates are not yet restrictive “ridiculous.”

“Tell that homebuyers paying 8% mortgage rates or banks scrambling for liquidity and sharply curtailing lending or manufacturers trying to fund their inventory with high adjustable-rate revolving credit,” Doty said. “Maybe Powell should carry an unpaid balance on his credit cards for a month and see how a 20% interest expense feels. Hint: it feels restrictive.”

He sees Treasury yields flattening “around 5% as inflation ebbs and economic growth stalls without contracting.”

Two situations that “could muck it all up,” according to Doty, are: a flight-to-quality as a result of global violence, which would drive down rates; or “heavy debt issuance to fund the fiscal deficit drains cash from the Fed’s repo facility. Debt supply overwhelms demand pushing yields higher and higher.”