Markets and Fed, A Bit 'Out of Sync'

AT A GLANCE

• In November, markets responded in the opposite direction of Fed guidance by taking longer-term rate expectations lower, not higher

• The U.S. Treasury yield curve has become move inverted, with the 1-year to 10-year spread widening from 60 to 100 basis points

The Federal Reserve does not provide specific investment advice, but they do provide guidance.

During the Nov. 2, 2022, press conference, Federal Reserve Chairman Jay Powell forcefully guided that federal funds rates might go higher and stay there longer than the markets expected.

Interestingly, the markets heard him loud and clear, but then did the opposite. Instead of rate expectations moving higher, the near-term rate expectations hardly changed, while the 2024 federal funds implied rate expectations dropped. Simultaneously, the yield curve became much more inverted, with short-term rates exceeding long-term yields by a larger margin. On Nov. 1, the U.S. Treasury 1-Year was trading about 60 basis points above the 10-year yield. By the end of November, that spread had widened to 100 basis points, or one full percent.

Increased yield curve inversion is a sign of elevated probability of a future recession. As such, our interpretation is that market participants were increasingly worried that a data-dependent Fed would not see through lagged, potentially improving, inflation data and would overshoot on rates, leading to more difficult economic challenges ahead.  So, markets responded in the opposite direction of the guidance, taking longer-term rate expectations lower, not higher.  That is, bond prices rallied, with yields moving lower.

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