Only Half Of Wall Street Disagrees With The Federal Reserve

The Federal Reserve’s current interest-rate-raising policy focuses on conquering too-high inflation. Wall Street’s future analysis anticipates the Fed’s success, thereby producing lower, stable inflation and interest rates. Therefore, there is no apparent disagreement between the Fed and Wall Street.

So, why are there reports of the two disagreeing? Because there are two sides of Wall Street’s outlook. One half agrees and the other half disagrees.

Wall Street’s two halves

First are the professionals that are especially focused on interest rates and inflation: bankers, bond analysts and bond fund managers. They are more closely aligned with the Fed’s thinking and actions, particularly taking into account the risks of being wrong about inflation. (Remember, fixed-income securities are at the mercy of inflation and interest rate moves. A shallow or moderate recession is of less concern and can even be welcomed.)

Second are the professionals especially focused on economy and business growth: investment bankers, equity analysts and equity fund managers. Their focus is on the risks of the Fed squeezing too hard and producing a recession. (Remember, where equities are concerned, inflation often accompanies growth. Therefore, these professionals are fine with stable, moderate inflation than with risking a recession to get inflation back down to 2%.)

The split is visible in these two Friday (Jan. 13) articles in The Wall Street Journal, although the terms, “money managers” and “investors,” are applied to both sides of Wall Street.

Front page: “Markets, Fed Split on Rate Forecasts“

“Many money managers predict inflation has peaked, and that price pressures will fall so fast that the Fed takes back some of its interest-rate increases by the end of the year, as it did in 2019 just seven months after its last hike.

“Fed officials have been hammering a different message: This time will be different because inflation is much higher.”

In the “Heard on the Street” section: “On Inflation, Investors Fight the Fed“

“So, investors think that inflation will come down quickly—that policy makers will end up raising rates by less than they think and will in fact be cutting rates by year-end. Policy makers probably worry that the investors’ optimism on rates could leak into the economy, making the inflation fight more protracted.”

Is 2% inflation really expected by Wall Street? No

Futures pricing currently shows expectations of declining interest rates starting by year-end. However, longer-term interest rates are well above the 2% level. A good way to see what Wall Street foresees is to examine the zero-coupon bond yield curve. Without interest payments, each bond accrues its interest rate over its term. By examining the compound rate for two different terms, we can calculate the interest rate for a future interval.

The table below shows the December 31, 2022, zero-coupon bond yields for each year, 1 through 10 (2023-2032), along with the interval (future year) yields. Note four items regarding the interval yields (last column):

• The yields for years 1 and 2 (2023-2024) are at the Fed’s current Federal Funds upper limit of 4.5%
• The yield for year 3 (2025) is still relatively high at 3.9%
• The yields for years 4 and 5 (2026-2027) decline to 3.6%, then 3.5% (the low)
• The yields for years 6 through 10 (2028-2032) show a normal, rising yield curve pattern from 3.5% up to 4.1%

So, even with interest rates having declined recently, each future year’s yield is priced well above 2%. In other words, Wall Street’s fixed-income side is including the risks of the Fed not succeeding quickly or fully – that is, they are considering a complete picture of possible outcomes, not just the most likely one.

From the first WSJ article, above:

“’To be honest with you, I don’t quite know why markets are so optimistic about inflation,’ said San Francisco Fed President Mary Daly after the Fed’s meeting last month. ‘I think of them as priced for perfection,’ she said.

“Fed officials, Ms. Daly said, ‘don’t have the luxury of pricing for perfection…. We have to imagine what the risks to inflation are.’”

The bottom line: Don’t bet on a single outcome

The number and size of uncertainties and risks in the markets now is abnormally high. That means that determining how to invest is particularly uncertain and risky. For stocks, it is challenging today because Wall Street’s equity side is focusing on the Fed’s end game coming soon, when happiness and growth return.

The Fed is warning that they’re not as confident, so expect higher interest rates with an uncertain effect. Moreover, the Fed works primarily from observed results rather than a favorite forecast. Additionally, the risk of being wrong and having to start over is, to the Fed, unacceptable.

So, while “waiting until the dust settles” is usually a losing strategy in investing, it looks appropriate this time. The possibility of growth slowing further and causing reduced revenues and earnings is high enough to hold at least some cash for coming opportunities. Ditto for long-term bonds. Why lock in today’s yields when the Federal Reserve is talking about more rate raising?

Becoming optimistic too soon can produce unhappiness, doubt and regret – emotions that make deciding what to do next difficult.