What if the markets are underestimating the Fed’s path of this tightening cycle
Market Strategist, Greater China
Summary: The market is pricing in rate cuts from the Fed in first half of 2023. What if inflation fails to come down sufficiently to allow the Fed to pivot and cut rates? The 3-month SOFR futures may fall when rate cut expectations wane.
The money market is pricing in peak rates in December 2022 and then rate cuts in 2023
Continuing the trend that has been in place since the June Fed meeting, the money market has since been pricing in lesser rate hikes for the remainder of the year and higher probability for cuts in early 2023. Currently, the markets are expecting the Fed to hike 50bp in September, 25bp in November and then may or may not hike in December before ending this current tightening cycle. Back-month Eurodollar futures (tracking 3-month USD LIBOR rate) and the 3-month SOFR futures (tracking the 3-month compound rate of the secured overnight financing rate) imply 3-month interest rates peak in December at 3.65% and 3.26% respectively.
SOFR is lower than HIBOR because SOFR is the weighted averages of repo rates, which are secured by U.S. treasury securities. HIBOR is calculated from rates for unsecured lending among banks. Historically, Eurodollar futures have been the most liquid exchange-listed futures for short-term interest rates and a good indication of where 3-month interests rate trade on forward dates over a multiyear horizon. However, as LIBOR is fading out, Eurodollar futures will stop trading and all open positions will be transferred to 3-month SOFR futures at a fixed adjustment of 26.161bp after end of June 2023. During this transition, we look at both the Eurodollar futures and the 3-month SOFR futures.
In Figure 1 below, prices of Eurodollar futures and 3-month SOFR futures imply that U.S dollar interest rates will fall slightly more than 25bp during the first half of 2023. By September 2023, interest rates will decline about 50bp. For the full year of 2023, 3-month interest rates will plunge by around 70bp to 2.90% (implied by Eurodollar futures) and 2.64% (implied by 3-month SOFR futures).
What needs to happen for the Fed to pivot and cut rates
Currently PCE inflation rate was at 6.8% and core PCE inflation rate was at 4.8%. Even if a recession kicks in early next year and inflation rates fall to around 3%, given the political implication of the inflation inflicted pain to a vast majority of Americans, the Fed may pause but it is difficult for the Fed to reverse course and cut rates. The Atlanta Fed’s sticky-price consumer price index which focusses on a basket of items that change price relatively slowly, such as rents, education, and medical care services, has reached 5.6% YoY (Figure 2). The Fed can no longer take comfort from the thesis that long-term inflation expectations are anchored. After the money markets has priced in a less hawkish path of Fed tightening cycle, the US treasury 5-year-5-year-forward breakeven rate, which is a market implied longer term inflation expectation measure, has bounced rapidly to 2.40% from 2.02% in a litter more than a week since July 21 (Figure 3). For the Fed to reverse course and cut rates as soon as in the first half of 2023 as currently being priced in by the Eurodollar futures and 3-month SOFR futures, inflation needs to come down dramatically to somewhere around 2.5% or at least below 3% in less than a year.
What if the runaway inflation train does not slow down to below 3%
If the inflation train does not decelerate and slow down its speed to below 3% a year, the market may be underestimating the pressure on the Fed to keep running, i.e. raising interest rates, in most part of 2023. The Eurodollar futures and 3-month SOFR futures may provide a mispricing opportunity for investors to take advantage from. Although Eurodollar futures are still the most liquid exchange listed money market instruments, their trading is doomed to terminate by the end of June in 2023 as governments have decided to disallow banks to use LIBOR. The liquidity of 3-month SOFR futures have increased rapidly and our discussion below will focus on them.
The 3-month SOFR futures, like the Eurodollar futures, are priced as 100 minus the compounded secured overnight financing rate per annum during contract reference quarter. The September 2023 3-month SOFR futures (SR3U3) is trading at 97.20, which implies a 3-month interest rate of 2.8% p.a. (100 – 97.2 = 2.8). Market participants who consider rate cuts in the fall in 2023 being premature or a low probability event, they may be selling the SR3U3 at 97.20 (i.e. 2.8%), targeting 96.75 (i.e. 3.25%) or lower (>3.25%). The resulted movements in the price of the 3-month SOFR contracts are reflecting the change in market expectations of the future path of interest rate movements.
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