Higher prices have led to tighter financial conditions. Mortgage rates up a lot, gasoline prices up a lot, UST yields higher, credit spreads wider. For the past five months, both the bond and stock market has basically been doing the Fed’s job for it – tightening financial conditions in the face of higher prices.
Tighter financial conditions will destroy demand, and that phenomenon is already underway. In the past week alone, housing starts looked soft, UST yields have started to fall, mortgage rates have started to fall, fed fund futures have started to fall, and gasoline futures have started to fall. Money supply – the source of the inflation – is cratering lower. As demand declines, inflation expectations should also fall. In the past two months, forward inflation expectations (measured in the bond world as “5 year breakevens”) have fallen -75bps. Still elevated but now declining. That’s a good thing for overall price pressures and an excellent thing for those looking for less market volatility.
The Fed might spend the rest of 2022 playing catch up and hiking rates, but do not be surprised to see them reverse course in a year’s time and actually start cutting rates in mid 2023 as the economy softens due to demand destruction. The Fed never misses an opportunity to miss an opportunity. I think they are cutting rates by June 2023.
Chief Investment Officer
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