The Big Idea

A roller coaster ride to start 2023

| April 21, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

In less than four months into 2023, we already have had four distinct swings in economic and Fed policy outlook. Financial markets thought recession in January followed by a month of booming economic data in February. Then the SVB and Signature Bank failures sparked renewed and more intense concerns about downturn. And as the worst fears failed to materialize, the outlook has gradually recovered.  As it happens, after all of this volatility, expectations for Fed policy are not much different today from where they were at the start of the year.

Stage One: Recession fears

The consensus among financial market participants and economists entering 2023 was that the economy would likely slip into recession before mid-year.  Most of the major December economic data released in January reinforced that view.  While the employment report was solid, core inflation was modest by recent standards, consumer spending fell in real terms and the ISM Non-Manufacturing Survey composite index plunged.

The FOMC slowed the pace of rate hikes to 25 bp on February 1. This brought the fed funds target range to 4.50% to 4.75%.  At that time, fed funds futures priced in only one more quarter-point increase in March and then a pause followed relatively quickly by easing later in 2023.

Stage Two: Economy turns stronger

The entire tone of the economic outlook turned on February 3 with the blowout January employment report—complete with meaningful upward revisions to 2022 job growth—and a vigorous bounceback in the ISM Non-Manufacturing Survey gauge. The theme persisted throughout the month, as consumer spending surged and inflation, both headline and core, jumped in January, along with upward adjustments to the late-2022 readings for both.

The string of robust data, for both the real economy and inflation, through the month of February led to a sharp reassessment of the Fed policy outlook.  This stage was capped off on March 8, when Chair Powell made his semi-annual policy appearance.  His prepared testimony was quite hawkish, noting the run of data detailed above.  Powell raised the possibility of reverting back to larger rate hikes and indicated that the peak of the rate cycle was likely to be higher than the FOMC had previously thought.

In response to that speech, the July fed funds futures contract yield surged to 5.59% and there was a broad expectation that Fed policy would be on hold at that level through the end of the year.

Stage Three: SVB failure/credit crunch

Just two days after Powell’s testimony, it became clear that SVB was in trouble.  One day after that, the FDIC put the bank into receivership and Signature Bank also failed over the weekend.  In the immediate wake of these two banks going down, there was a broad expectation that other regional banks would likely also need government help. During the next weekend, Credit Suisse was acquired by UBS.

Financial market participants then expected a broad and abrupt tightening in credit and viewed the prospects of recession as near certain, even more so than in January.  In 10 days, the July fed funds contract rallied by 110 bp so that investors were expecting Fed easing by July, followed by additional rate cuts later in the year that would take the funds rate well below 4% by year-end.

Stage Four: Ruling out the worst case

While credit conditions are reportedly tightening, the worst case did not transpire.  More than a month after the CS acquisition, no other banks have failed.  In recent weeks, first quarter bank earnings have predominantly surprised to the upside, and the H.8 data show that deposits actually began to rebound in early April, a finding echoed by some individual banks in their earnings reports.

Moreover, while the economy is posting only modest growth, the labor market remains strong, albeit finally cooling, and inflation is proving stubbornly high.  The FOMC contributed to a sense that policy would not be dramatically affected by the banking turmoil when it hiked by 25 bp on March 22 and issued a new round of dot projections showing that a majority of policymakers still expected a peak rate of 5.125%—the same as in December.

Since bottoming out on March 17, market expectations for the peak fed funds rate have steadily reversed and in recent days have moved roughly to the median dot projection for end-2023 of 5.125%.  However, as of April 20, investors were still pricing in over 50 bp of easing in the second half of the year, despite frequent admonitions from policymakers that a prolonged period on hold is more likely.

Two questions

Expectations regarding monetary policy in 2023 can be summarized by two parameters: 1) what will be the peak funds rate, and 2) when will the Fed begin to ease?  Right now, the FOMC’s answers to these questions, based on the March dot projections is 5.125% and not until well into 2024.  The July 2023 and January 2024 fed funds futures contracts can serve as rough proxies for detailing financial market participants’ answers to these two questions.

Exhibit 1 shows the daily yield of the July 2023 fed funds futures contract.  The red vertical lines divide the four stages described above.  This timeframe does not offer a perfect gauge of the peak rate for the year, but it is reasonably close.  You can see that we started the year in the 5% vicinity and are currently just above that level, but the price action in between has been extremely volatile.

Exhibit 1: July 2023 fed funds futures contract yield

Source: Chicago Board of Trade, Bloomberg.

Exhibit 2 shows the same time span for the January 2024.  This offers the cleanest read on the year-end funds rate, because the contracts are bets on the monthly average for the funds rate, and the first FOMC meeting in 2024 ends on January 31 (so that the January 2024 average should be almost exactly the same as the December 31 level, even if the Fed makes a policy move at month-end).

Exhibit 2: January 2024 fed funds futures contract yield

Source: Chicago Board of Trade, Bloomberg.

As with the July 2023 contract, the gyrations have been extreme, but the expectations for the funds rate at year-end are about where they were to start the year, modestly above 4½%.

In my view, Exhibit 3 offers a solid proxy for the amount of easing priced in for the second half of 2023, the gap between these two futures contracts.  During Stage One, in January, expectations were for about 50 bp of easing in the second half of this year.  During Stage Two, when the economic data strengthened, that gap closed all the way to almost zero.  Then, in the immediate aftermath of the SVB failure, it ballooned to over 75 bp, and since then has slowly narrowed and is back to around 50 bp.

Exhibit 3: Difference between July 2023, January 2024 fed funds futures

Source: Chicago Board of Trade, Bloomberg.

As I see this, the renormalization of Fed policy expectations since the early days of the March banking episode has come in two legs.  First, expectations for near-term policy, i.e., what the peak of the cycle would be, needed to revert back to the FOMC’s guidance.  That leg is complete as of last week.

The second leg is that, assuming the economy is not severely damaged by tighter credit conditions, investors will likely need to slowly wring out expectations of Fed easing later this year.  That process is well underway, but, as of last week, still has about 50 bp to go.

Of course, if the first four months of the year are any indication, the path forward will be anything but a straight line!

Stephen Stanley
stephen.stanley@santander.us
1 (203) 428-2556

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