Stronger Conviction on Close to 8% Terminal Rate

What a week!

Reactions to the Fed add to my conviction on my call for a close to 8% terminal rate, though I have changed my view on how the Fed gets there. I am now thinking we get there by the Fed reacting to strong actual inflation data and hiking about 75bp/meeting, which would bring us to close 8% by mid-2023. Previously, I thought the Fed would slow hiking to assess the impact of the fastest pace of hiking in 40 years, and eventually capitulate at the March 2023, and announce a much higher terminal rate. What made me change my mind is the dot plot showing 125bp hikes by end-2022.  See my full FOMC review here.

Before I get to the reasons for my stronger conviction, I note that my view is becoming more mainstream with John Authers noting in his daily that a benchmark for ‘meaningfully restrictive’ rates is when the FFR exceed the inflation rate. The need for a positive real FFR (i.e., a FFR getting close to the Taylor rule) is a key reason for my FFR call.

Adding to my conviction:

• The resiliency of credit (Chart 1) shows why stabilizing inflation could be a challenge for the Fed. As John Tierney keeps reminding me, corporates have taken advantage of the 10+ years of very low interest rates to lock in LT funding at very low rate. So, corporates won’t feel the pinch from higher yields until they have to refinance their debts, which is likely to be a while away.

• The medias are lamenting the decline in residential real estate listings. But this is supporting housing prices. Basically, supply is falling to reflect lower demand. This reflects the very strong balance sheets of households, enabled by very low rates and 10+ years of deleveraging. By contrast with the GFC, households are able to keep their houses and rent them out. This means rents are not about to fall anytime soon.
• I am reading a lot of comments about earnings forecast needing to come back to earth. These are the earnings forecast coming from businesses bottom up. Granted, corporates tend to be optimistic when it comes to their forecasts. But they cannot be too optimistic as it would eventually hurt them. These resilient bottom up earnings forecast are consistent with my view that the tightening of financial conditions is not impacting growth that much. As in Q2, earnings could actually surprise on the upside.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

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