IYY - The Fed Could Raise Rates To 6%

Summary

• Rates could be heading to as high as 6%.
• The economy remains resilient due to the recent easing of financial conditions.
• Financial conditions will need to tighten again to kill inflation.

The recent easing of financial conditions, as rates and the dollar rise, and as the market reassesses the Fed's terminal rate, following a hot CPI report, and blow-out retail sales data - it has been a pile-up of better-than-expected economic data for January, suggesting the Fed's job is far from over.

Retail sales in January rose by 3% vs. estimates of 2%. Overall, this will only raise more questions about how far the Fed will need to raise rates because the Fed Funds Futures market is currently pricing in a policy rate above that of the December dot plot for a range of 5 to 5.25%. As of the Feb. 14 close, the futures contracts for August were trading at 5.28%.

SOFR Futures options suggest that bets are being placed on rates climbing above 5.5% in 2023 and potentially as high as 6%. As noted previously , there have been soaring open interest levels for the September 2023 SOFR 94 and 94.50 put options, which imply a rate of 5.5% to 6%. More recently, the SOFR December 2023 94 and 94.5 put contracts have also seen a similar surge in open interest levels, suggesting a 6% terminal rate may not be as far-fetched as it would have seen just a few weeks ago.

Especially if inflation stays sticky and the economy remains strong. Inflation swaps following the January CPI have also increased, with the February contract now trading at almost 6%, jumping from 5.8% before the CPI report and up from 5.22% on Jan. 6.

Meanwhile, the Atlanta Fed Sticky 12-month CPI is now at 6.55% and down just a tick over the last month's cycle high of 6.61%, showing hardly any sign of improvement.

The market continues to reprice rates and even contemplates a terminal rate potentially going as high as 6% due to rising inflation expectations. The dollar is likely to start strengthening again because, let's face facts, at the beginning of the year, most of the market was focused on a US economy heading toward recession. Now, a month into the year idea of a recession seems further away than previously thought.

The better-than-expected outlook is reflected in the dollar index, which has risen sharply over the past few sessions, and the more it rises, the tighter financial conditions shall become. The dollar index played a hand in the easing of financial conditions coming out of the pandemic and a very heavy hand in the tightening of those conditions in 2022. It's no surprise that the recent easing of financial conditions has been associated with the dollar weakening.

So the implication of monetary policy going higher is likely to result in the tightening of financial conditions as it works toward slowing the economy. Additionally, as we know from last year, the tighter financial conditions get, the more of a struggle it will be for stocks to advance. Tightening financial conditions suggest that rates rise, credit spreads widen, the dollar strengthens, implied volatility rises, and stock prices fall.

So as long as the economic data remains strong, and the market begins to price in even higher rates, potentially even as high as 6%, the path forward means financial conditions should begin to tighten again, which means the next leg of the bear market resumes.

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