Rates have remained high for a long time. Blame Canada?
In a surprising turn of events, this week’s biggest market mover for interest rates was a policy announcement by the Bank of Canada (BoC). The event was credited with prompting a re-think of the US Federal Reserve’s rate outlook.
Notably, the BOC raised rates despite almost half of the market’s belief that it would hold steady. While the Fed’s chances of holding steady at next Wednesday’s announcement look much better, the argument this week was that central banks may be erring on the side of tough love because of believing that inflation will ease.
If we look at the year-on-year figures, it is clear that inflation is coming down. The following chart shows both the monthly and annual versions of the Consumer Price Index (CPI) at the “core” level (which excludes the more volatile food and energy prices). As far as rates are concerned, the core CPI is the most relevant inflation data. The next release is next Tuesday, a day before the Fed announces whether it is going to hike rates again.
If we just zoom in on the monthly numbers, we see a different theme. Inflation is still well above the target level and is still trying to make up its mind towards the next move.
This inflation dynamic is responsible for the division of opinion on the Fed’s next move. Indeed, it is better to think of the uncertainty in terms of the longer-term fed funds rate path. In fact, the Fed is unlikely to hike next week (unless the CPI far exceeds expectations). Traders have been more interested in adjusting their expectations for where the Fed will be by the end of the year. Less than a month ago, futures markets were betting on a full rate cut by December. As of Friday, the same metrics suggest the Fed may not cut rates in 2023.
Note, this week all the upward movement in the blue line happened before any news out of Canada. Things slowed down significantly in the bond market as investors knew they were waiting for a huge week ahead. The BOC rate hike certainly caught the market’s attention in the near term, but higher jobless claims data pushed the yields back down the next day. The following chart highlights those events as well as other big impacts on rates, starting with last Friday’s jobs report. (Note: Jobless claims and the “Jobs Report” are two different data sets. They sometimes disagree).
At this point, we should pause to ask how much we really care about the fed funds rate (which the Fed is raising at its fastest pace in decades). While there is a broad correlation with mortgage rates, there are many examples of long-term rates moving in the opposite direction from the Fed. Things get especially difficult when the Fed ends or is almost done hiking. Note the decline in mortgage rates the last time the fed funds rate hit the type of plateau the market is currently anticipating.
In addition to making a rate hike (or “pause”) decision, next week also brings the quarterly release of Fed members’ rate outlook for the next few years. No one has foresight expectations, but predictions do provide insight into the Fed’s approach to whether to pursue a rate hike (or pause, or cut). Last but not least, Fed Chair Powell will hold the customary press conference 30 minutes after the rate decision and updated forecasts are announced at 2 p.m. ET. This all happens on Wednesday when CPI data from the previous day at 8:30 AM ET is brought in.