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In One Chart: The market is getting in the way of the Fed pivot the market so badly wants, say Bank of America strategists

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There’s nothing financial markets want more than a pivot from the Federal Reserve in its interest-rate hike campaign.

There’s one key problem — the market itself.

That’s according to analysis from rates strategists at Bank of America. “The Fed would likely find it difficult to lower inflation if financial asset prices are rising. Inflation typically falls after a sustained period of reasonably tight financial conditions (FCI) or an acute financial conditions shock,” say strategists led by Mark Cabana.

They point to a chart overlaying the Chicago Fed’s measure of financial conditions with a measure of inflation, called the trimmed mean. “The market wants to believe peak hawkish Fed is past. We are skeptical. Watch for another hawkish dose at Dec FOMC,” they add.

The S&P 500
SPX,
-0.12%
,
down 25% on the year as recently as October, is now down just 15% on the year.

Bank of America

They note the market is expecting the terminal rate to be reached in March or May, and the first full cut in November. They say that gap — between peak and the first cut — isn’t unusual, though seems short relative to cycles after 1995. What’s even more unusual is the extent of cuts priced afterward, some 170 basis points worth in 1.5 years.

“Heavy cuts post terminal suggest that the market is skeptical of the Fed’s higher for longer message,” the strategists say. There are two ways the Fed could address this skepticism — one would be by using the dot plot, and putting the 2024 dot over the 2023 dot. Another would be providing forward guidance on inflation and unemployment, for instance by saying it won’t cut rates until core PCE inflation was equal or below 3.5%. But the strategists don’t expect the Fed to adopt either approach.

The end result, the strategists say, is that the premature pivot concerns will build, lower real rates, and that a higher Fed terminal rate seems likely, which will flatten the curve.

On Monday, the yield on the 2-year Treasury
TMUBMUSD02Y,
4.316%

was 4.32%, and the yield on the 10-year
TMUBMUSD10Y,
3.516%

was 3.52%.

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