Financial markets are at odds with the Federal Reserve on the direction of monetary policy over the next couple of years, according to a Deutsche Bank (XTER:DBK, Financial) research note posted earlier this week.
While the Fed has repeatedly stated that it is unlikely to raise rates before 2024, the market continues to price in a lift-off by around year-end 2022, and three cumulative rate increases by 2023.
To explain this expectation gap, Deutsche Bank conducted a brief targeted survey of its fixed income clients, which revealed the source of the gap is inflationary expectations. Survey respondents expect that the core Personal Consumption Expectations Index—an inflation gauge closely followed by the Fed, to be in the 2.2% to 2.3% range in 2022 and 2023.
"This result of a modest overshoot of the Fed's target in the coming years and earlier lift-off is consistent with recent readings on forward break-even inflation rates and front-end market pricing," the report read.
Meanwhile, Duetsche Bank identified another potential source of this gap: a misunderstanding of the Fed's reaction function. The report noted:
"We learned at the FOMC meeting that 2.1% core PCE inflation is not sufficiently high to trigger lift-off, it is still unclear whether inflation rates in the 2.2-2.3% range – as expected by our survey and market pricing -- would be high enough to get the Fed to tighten. This ambiguity is one drawback of the Fed's flexible average inflation targeting (FAIT) approach which leaves key parameters undefined."
Simply put, markets think the Fed is "behind the curve" in fighting inflation. Thus, fixed-income investors and traders have been selling T-bonds, driving their yields higher. The yield on the benchmark 10-year Treasury note touched 1.669% on Friday, three times higher than last Augusts's low of 0.55%.
Meanwhile, Fed Chair Jerome Powell hasn't missed the opportunity to reiterate that any spike in inflation would likely be temporary and, therefore, the recent rise in bond yields will eventually taper off.
What could bridge the gap between the Fed and the markets? Better communication.
"If the Fed were to clearly signal that core PCE inflation in the 2.2-2.3% range for a year or two is consistent with their view of FAIT and would not trigger a tightening of monetary policy, they could impact market pricing," Deutsche Bank said. "Conversely, if the FOMC believes they would raise rates in response to these inflation realizations, then the market is currently pricing an appropriate reaction function and it will take some time for a verdict on whether the Fed or market is correct about the persistence of this inflation shock."
Disclosure: No positions.
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