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Market Extra: Investors fear ‘ship has sailed’ on soft landing with risk of fed funds headed for 5% in 2023

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Financial market participants appeared to be losing hope that the world’s largest economy can avoid a downturn, a day after the Federal Reserve left little doubt about its willingness to continue aggressively hiking interest rates to curb inflation — leaving traders contemplating a once-unthinkable 5% level for borrowing costs in the next six months.

“Our view is that a fed-funds rate of 4% is about the highest that the economy would be able to withstand, and the Fed is clearly threatening to raise rates above that level,” said Mark Haefele, chief investment officer at UBS Global Wealth Management.

Amid a worldwide march higher in rates, which also included hikes by the Bank of England and central banks of Switzerland and Norway, major stock indexes from U.S. to Europe and Asia were mostly a sea of red as investors and traders factored in a decent chance of a 5% fed-funds rate target next year — twice as high as where rates were prior to the Fed’s policy announcement on Wednesday.

In the U.S., stocks extended their losses after suffering a sharp Wednesday decline; government bonds aggressively sold off, pushing 2- and 3-year rates further above 4%; and the U.S. dollar — seen as one of the few remaining havens in the current environment — climbed further above its highest levels of the past 20 years, as measured by the ICE U.S. Dollar Index DXY.

Meanwhile, bond-market indicators continued to flash warning signs, through a deeply inverted Treasury yield curve, of the growing risk of a recession and analysts were skeptical that policy makers can avoid one. For his part, Fed Chairman Jerome Powell told reporters that “no one knows with any certainty where the economy will be a year or more from now.”

Economist Derek Tang said “the ship has sailed” on the prospects of a soft landing, while Chris Low of FHN Financial called out a “fantasy element” in the Fed’s economic forecasts, which show the U.S. economy strengthening in 2023 despite a fed-funds rate heading for 4.6%. Jefferies economists Thomas Simons and Aneta Markowska said “Nobel Prizes will be in order” if the Fed can achieve its goal while avoiding a recession.

UBS Global Wealth’s forecasts see a chance that inflation may fall low enough for the Fed to possibly pause its rate-hiking cycle after its December meeting, Haefele said in a note Thursday. “However, if inflation does not come down as quickly as we expect and the Fed raises rates closer to 5%, it will be difficult to avoid a recession.”

Indeed, traders were pricing in a 31% chance that the fed-funds rate target could get to between 4.75% to 5% by March, up from 19% on Wednesday and zero chance a month ago, according to the CME FedWatch Tool. A slight chance was also seen that the target could get as high as 5% to 5.25% in six months — versus the current level of 3% to 3.25%, following the third straight 75-basis-point increase.

What’s more, six out of the 19 officials on the policy-setting Federal Open Market Committee indicated they think it would likely be appropriate to lift rates to between 4.75% and 5% next year, according to the Fed’s economic projections released Wednesday. BofA Securities and Deutsche Bank have also flagged the chance of rates moving closer to 5%, a level that hasn’t been seen in over a decade.

To be sure, a 5% fed-funds rate is still not yet a universal view: trader Tom di Galoma at Seaport Global Holdings in Greenwich, Conn., argued that “inflation is going to subside dramatically by the beginning of next year or there will be geopolitical developments that are going to force the Fed into some kind of pivot.”

Read: Markets ignore Putin’s nuclear saber-rattling. Why that might change.

Still, markets were aggressively readjusting their expectations for Fed policy, with the 2-year Treasury yield

being one of the rates taking the brunt of the selloff in bonds. More than any other rate along the Treasury curve, the 2-year rate is “the most related to policy expectations” and offers “the purest call on what the Fed is going to do,” said Tang, an economist at Monetary Policy Analytics in Washington, led by former Fed governor Larry Meyer.

Unlike the 10- and 30-year rates, the 2-year is “not as tainted by term premiums and the supply-demand effect, in which some people hold Treasurys for strategic reasons,” he told MarketWatch.

On Thursday, the 2-year rate continued to climb toward a 15-year high — breaking past 4.1%, along with the 3-year yield, as the 5-year rate also moved higher in sympathy. In the process, the 2-year yield exceed the yield on the 10-year Treasury note by as much as 59 basis points at one point, deepening the inversion of that measure of the yield curve.

The 2-year yield matters because its relationship to the 10-year is one of the ways in which the bond market can provide a relatively reliable warning of a future recession, albeit with a lag. In addition, an inverted curve, in which the 2-year rate trades above its 10-year counterpart, has the potential to impact banks’ willingness to lend — which in turn can bring down demand in the economy, by making it more expensive to borrow and companies less willing to invest or hire.

Growing expectations for a 5% fed-funds rate would eventually be reflected in the 2-year rate, according to Tang. And if the Fed brings such a level to fruition, “that would be an unequivocal message to businesses to stop hiring, stop poaching employees, and stop raising wages,” the economist said via phone. “It would be a way to shut down the sort of revenge high-spending streak people have been going on” since the pandemic began by making people feel less rich, and would further hit the housing market and equities — particularly shares of technology companies, with future earnings that would be seen as less valuable by investors, he said.

Indeed, a continued rise in U.S. mortgage rates is already taking its toll on housing sales. The S&P 500 index

is in the midst of a slide described by Bespoke Investment Group as the third leg down in the current bear market. And the Nasdaq Composite
which led major U.S. indexes lower on Thursday, was down 29% for the year as of afternoon trading.

Meanwhile, an unruly rise in the U.S. dollar has left currencies like the yen at the lowest levels in more than 20 years — forcing Japanese authorities to intervene in currency markets to buy their currency.

Against the current backdrop, “we do not consider this an environment suitable for strong directional positioning on overall indexes,” Haefele of UBS Global Wealth wrote. “But we advise against retreating to the sidelines, especially given the drag on cash from high inflation and the challenge of timing a return to markets without missing out on rebounds. Instead, we stay invested but also selective, and focus our preferences on the themes of defensives, income, value, diversification, and security.”

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