Market Expects the Rate-Hiking Cycle May Fall Behind the Curve

October 21, 2021

Source: Bloomberg Source: Bloomberg

The U.S. 10-year Treasury yield topped 1.6% last Friday in the wake of an unexpected strong retail sales figure and high inflation pressure. Where will yields be long term? Treasury yields can be decomposed into two parts: short-term rate expectations and term premium. The future path of short-term yields is guided by expected rate hikes from the Federal Reserve (Fed), while term premium is primarily driven by inflation expectations and Treasury bond supply/demand.

This week’s chart shows the Fed’s expectation for rate hikes (the so-called Fed dot plot) versus the bond market expectation for hikes through the pricing of Fed Fund futures. The futures market is pricing in that the Fed will have an early and aggressive reaction in 2022, but a slower pace afterward. The market anticipates a more moderate pace of rate hikes similar to the last rate-hiking cycle in 2015-2018. However, I think there are three reasons that today’s situation is completely different from the last cycle, indicating that the Fed may hike rates faster than expected.

First, this recession was caused by the COVID-19 pandemic, an exogenous factor. Generally, financial system and household balance sheets are stable and healthy. The economy recovered quickly after the lockdown lifted and vaccines were rolled out. During the period of recovery, there does not need to be a slow, long-term deleveraging process. In contrast, the great financial crisis was driven by endogenous factors, and the leverage ratios in the banking system and households were much higher. Moreover, it caused structural damage in the entire U.S. financial system. Each component needed time to repair its balance sheet, which slowed the speed of economic recovery and policy normalization.

The second reason is that fiscal policy played a major role in this recession compared to the 2008 financial crisis. The government passed stimulus and relief packages, and has an infrastructure bill on the horizon. According to McKinsey, the total stimulus during for the COVID-19 crisis has already tripled the amount provided for the entire 2008-09 recession. This tremendous fiscal stimulus sped up the rebound and allowed the economy to avoid excessive reliance on solely monetary policy. If the economic rebound becomes weaker afterward, fiscal policy will support the recovery while monetary policy is normalizing.

Last, but not least, is inflation. Fed Chair Jerome Powell initially claimed inflation is transitory, but inflation risk cannot be ignored. Under historical fiscal and monetary stimulus, with COVID-19 cases slowing down double effects, the previously suppressed demand quickly released. While consumer demand took off, businesses have been scrambling to catch up. Meanwhile, wages and owners’ equivalent rent, non-transitory components in the Consumer Price Index, have shown signs stronger, persistent inflation is materializing. Fed Chair Powell has changed his tone recently, noting that supply-chain bottlenecks could lead to a longer interval of high inflation.

Key Takeaway

The market is pricing in two rate hikes in 2022, but risks are increasing that the Fed will need to be more aggressive in the next rate-hiking cycle. Financial market volatility is likely to increase alongside risk premiums should the Fed begin to communicate more hawkish messaging to investors accustomed to ultra-low interest rates and easy credit conditions.       

Tags: Federal Reserve | Treasury yields | bond market | rate hikes | COVID-19 pandemic | Market volatility | Interest rates

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