SPXV - The Fed Minutes May Reveal A Steep Rise In Rates On The Horizon

Summary

• Fed minutes will be released on Wednesday, February 22.
• Hot economy data suggest the Fed is nowhere close to pausing its rate hiking cycle.
• That means that rates will be even higher than previously thought.

This week's Fed minutes could reveal a few surprises to investors, but more importantly, it is likely to lay out the Fed's plans for the path of rate hikes. Powell referenced at the FOMC meeting that the minutes would reveal the Fed's discussion regarding what it is looking for to decide when to pause its rate hiking cycle.

One of the big surprises will likely show that not all Fed members were on board with slowing the pace of rate hikes. This past week, Cleveland and St. Louis Fed Presidents Loretta Mester and Jim Bullard noted they would have favored a 50 bps rate hike. Neither of them is a voting member, perhaps giving them room to be on the more hawkish side of things.

Higher For Much Longer

While the minutes may not reveal much new, they will likely confirm that no pause is coming soon. The hurdle for pausing is high enough that the risk is that the Fed will have to raise rates higher than previously thought and that rates may have to stay higher for much longer than previously thought. The most significant adjustments to the Fed Funds Futures curve have come at the back of the curve, with the August 2024 contracts rising by nearly 100 bps over the past month.

Additionally, the minutes will likely reflect the desire to see several months of inflation data, suggesting the Fed is on pace to reach its 2% target. Additionally, the minutes will reflect that the job market remains too tight and that wage pressures are not consistent with a 2% inflation rate, while the number of job openings remains high relative to the number of unemployed and that softness in the labor market has not developed yet. The Fed has desired to slow the economy without killing the job market. The easiest way to bring the supply and demand dynamic back into balance is to slow demand so that the number of job openings to the number of unemployed falls back to pre-pandemic levels. Meanwhile, a rising labor participation rate would be highly desirable.

Data Is Not Supportive For A Pause

The January job report showed that the unemployment rate fell, and job openings remained very high. This has left nearly two job openings for every unemployed person. On top of that, the recent wage growth in January ran hotter than expected on a year-over-year basis at 4.4%, while December's data was revised higher to 4.8%. To achieve a 2% inflation rate, the Fed would likely want to see wage growth of around 3%.

Additionally, the combination of the hot CPI, PPI, and stronger-than-expected import prices ex-petroleum suggest that the pace of inflation has slowed, but they also indicate that it isn't going to vanish either.

This week's CPI report suggests that inflation is not currently on pace to reach the Fed's target. All it took was three months of financial conditions easing for January's CPI to rise by 0.5% for the month. The PCE report on February 24 is also expected to show that inflation was strong in January, rising by 0.5% month-over-month, up from 0.1% in December and up 5% year-over-year, in line with December. Meanwhile, core PCE is expected to rise 0.4% in January, up from 0.3% month-over-month in December and up 4.3% year-over-year, versus 4.4% in December.

Financial Conditions Should Begin To Tighten

All of the data suggests a Fed pause is nowhere close, and now the market is pricing in rates going higher than the Fed's December projections. The August Fed Funds Futures contract is now trading at 5.3%, which suggests an additional 25 bps rate hike likely in June. The expectations for higher terminal rates have helped to lift bond yields and strengthen the dollar, and high yield credit spreads to widen, which have also helped to start tightening financial conditions.

The tighter financial conditions become, the more stocks will struggle, and that effect of tight conditions has already been witnessed. The Goldman Sachs financial conditions index has risen to 99.87 from 99.40 on February 2. That has resulted in the S&P 500 falling from 4180 to 4079 over the same time. As conditions tighten further, the S&P 500 is likely to fall further.

The minutes are likely to confirm to the market that it will take significant further progress to meet the Fed's goal to pause, which should help tighten financial conditions further and start to slow the economy.

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