The market’s expectation is that the Federal Reserve will keep lifting its policy interest rate until it brings it to 5%, before pausing for some time.
But it’s possible that the Fed could decide that 5% is not nearly enough. That would be the case if the U.S. economy continues growing at a solid clip and inflation doesn’t substantially cool off.
Strategists at JPMorgan led by Nikolaos Panigirtzoglou decided to examine that very scenario, where the Fed would take its benchmark rate to 6.5% during the second half of 2023. They note that the JPMorgan economics team assigns a 28% likelihood to that scenario, so its within the realms of possibility, even though the rates market only assigns a 10% probability to that outcome.
In discussions with clients, that scenario is widely perceived as the Armageddon scenario. “After all the last time the Fed funds rate was at 6.5% was in 2000 and that level of policy rates was followed by very heavy losses for risk markets at the time,” they say.
But the JPMorgan team wouldn’t expect actual Armageddon to take place in financial markets. “In our opinion while there is little doubt that [Fed rates at 6.5%] would be negative for most asset classes including equities, bonds and credit, the eventual downside is likely to be more limited that an Armageddon would suggest,” they say.
Net debit balances in NYSE margin accounts are at low levels.
Demand for bonds, they note, has already collapsed, and it’s expected to remain weak as central banks engage in quantitative tightening. “This unprecedentedly weak demand projected for 2023 raises the hurdle that demand would post another big negative surprise in 2023 and increases the risk of an upward surprise,” they say. Plus, supply is forecast to drop by $1.7 trillion next year.
Granted, the Fed taking rates to 6.5% would have big implications on the short-end
of the Treasury yield curve. But yields on the longer end would rise “by a lot less,” implying an even starker inversion than what we’re seeing now.
They make similar comments on the U.S. stock market, based on CFTC data on leveraged funds and asset manager positioning. “All these equity demand indicators stand at rather low levels creating an asymmetric backdrop where another big decline seems a lot less likely for 2023,” say the analysts.
Already, they note, the S&P 500 index
has been basically unchanged over the last seven months even as the peak in Fed pricing has climbed to 5% from around 3% in May.