With monetary policy, what matters most is the destination, not the journey. What ultimately shapes the economy and markets is not a central bank’s tactical moves, but how much it eventually raises interest rates.
Driving the news: Now, a seismic shift is underway in the outlook for the so-called terminal rate of this tightening cycle.
- Since a high inflation reading Tuesday, expectations have grown that the Fed will end up hiking much higher than seemed likely a week ago. It’s causing stock prices to tumble and the odds of a recession to rise.
Why it matters: If the outlook rapidly being priced into markets becomes a reality, it marks the end of an era in which rates seemed perpetually locked near zero.
- Just maybe, ZIRP (zero interest rate policy) is no more. That, at least, is now priced into the bond market, with one-year Treasurys now yielding more than 4%, the highest since 2007.
By the numbers: On Sept. 9, for example, futures markets priced in less than 1% odds that the Fed’s target rate will be above 4.5% by February. By Friday morning,t those odds had risen to 36%, according to the CME Group’s calculations.
- In a mechanical sense, higher interest rates make each dollar of future earnings worth less today. That helps explain why the S&P 500 is down 7% since Monday’s close (as of 10am EDT Friday).
The mainstream view is that the Fed’s target rate will reach the ballpark of 4% at the end of this year. That rate is currently just under 2.5%. Some commentators now see a rate target near 5%, or something close to it, as likely.
What they’re saying: Economists at Deutsche Bank analyzed the potential endpoint for the Fed’s target rate using a few different approaches and found they all “suggest that a fed funds rate at or around 4.5% could be required by early next year.”
- But chief U.S. economist Matthew Luzzetti and three colleagues argued in a research note published yesterday that, “accounting for risk management considerations, a rate approaching 5% is likely to be needed.”
That seemingly small difference has massive implications for financial assets.
- Ray Dalio, the founder of massive hedge fund Bridgewater, argued in a LinkedIn post that if the Fed ends up pushing rates to 4.5%, it implies a 20% decline in stock prices because of the higher discount rate for future earnings, as well as lower incomes.
What’s next: Following its policy meeting concluding Sept. 21, Fed officials will release new forecasts of, among other things, their own expectations for the path of interest rates.
- In June, the median official thought rates would top out at 3.8% at the end of next year; on Wednesday, we find out whether they’ve upwardly revised those forecasts.