Bilal’s Macroscope: Does the Market Ever Get the Fed Right?

At the start of 2022, the rates market expected the Fed policy rate to end the year at 1%. It turned out to be 4.5% – one of the biggest market errors in decades (Chart 1). Even by the summer of 2022, when the rate had reached 2.5%, the market expected the Fed to hike to 4% by May 2023 and start to ease in the second half of 2023. But here we are with the Fed 125bps higher at 5.25%.

The market still expects the Fed to cut rates in the second half. And it seems even more sure with 75bps cuts priced for this year. Given the market’s terrible track record, can we trust this pricing? Looking at history, the answer appears to be a resounding ‘no’:

• During the 2015-2018 hiking and 2019-2020 easing cycles, the rates market predicted the hiking cycle would start much earlier and end much later than it did. The market also underestimated the scale of easing.

• During the 2004-2006 hiking and 2007-2009 easing cycles, the rates market constantly underestimated the pace of both hikes and easings.

• During the 1994-2001 protracted hiking and easing cycle, the rates market again underestimated the pace of hikes at the start of the 1994 cycle, then overestimated the terminal rate at the end of this hiking phase (Chart 2). Markets then struggled to price the subsequent pauses and underestimated the 1999-2000 hikes and 2001 easings.

Today, markets appear to be taking heed of the 2015 and 2004 Fed cycles, trying not to get caught out by the pace of possible Fed easings. However, they are ignoring the possibility of the 1994-2001 scenario – when there was no clean cycle. Instead, the Fed ended its initial 1994 hiking cycle then paused for four years with small easings and hikes along the way, only to restart a hiking cycle in 1999 (Chart 2).

Today, one glaring difference from all these cycles is US inflation. It is around 5% – a level at which the Fed has never paused, let alone eased (Chart 3). Markets appear to be saying inflation will tumble soon or we are at the beginning of a financial crisis. Markets keep getting inflation wrong, so we would be cautious on the first prediction. Meanwhile, if a financial crisis is imminent, why are equities trading so well? We stay cautious on equities as a result.

Our Current Discretionary Trades

Over the past week, we added 1-year tenor receiver swaptions, short 10Y Bund and short EUR/USD trades and closed our short USD/CNH trade. Our portfolio has returned +5.9% YTD and +52.2% since inception (+13.0% annualised) with a 2.0 Sharpe ratio. Our current positions are as follows:

DM

• 1-year tenor receiver swaptions – read here.

• Short 10Y Bund (target: 2.50%; stop loss: 2.10%) – read here.
• Short EUR/USD (target: 1.05; stop loss: 1.125) – read here.
• Duration neutral US 2s10s steepener – read here.
• Short BTP vs Bund 10-year (target: 220bp) – read here.

EM

1. China re-opening – read here.
   • Long SHCOMP (target: 3,600)
   • Receive 2Y INR OIS (target: 6.0%) – read here.
   • Short USD/COP (target: 4,100)
2. EM to rally – read here
   • Short USD/IDR 3M NDF (target: 14,000)
   • Short EUR/CZK (target: 23.25)

Recent Questions From Clients

• How do you hedge against a US debt ceiling crisis?
• Will BoJ hike rates this year?
• Has China developed more of its chip-making capabilities than many think?
• Why have BoE/analysts got the economy so wrong?
• What pushback have you got on your short EUR/USD view?

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)