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"You Can't Fight The Curve": Rates Curve Is Saying There's Little Upside To Another Fed Hike

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by Tyler Durden
Tuesday, Apr 18, 2023 - 10:30 AM

By Simon White, Bloomberg markets live reporter and analyst

The market is anticipating one more hike from the Fed, but the short-term interest rates curve intimates there are rapidly diminishing benefits to higher rates, while their adverse costs continue to rise.

Barring the unexpected, it looks as if the Fed will raise rates 25 bps at its May meeting. However, the battle the Fed has fought with the curve has reached the point where raising rates again will have a negligible additional impact on quelling inflation, while the costs could still have an undesired negative impact.

The fed funds curve is now almost completely negatively inverted. What this means is that one more hike will be minimally transmitted along the curve out to longer maturities where it would be able have a greater impact on constraining inflation.

Indeed, this is the first time that the very front of the fed funds curve has been inverted in the run up to the last hike. Thus each previous tightening cycle the Fed’s last hike has had more ex ante demonstrable benefits.

Given the shape of the curve, and the stubbornness of the pricing in of a “Fed pivot,” another hike would raise only the spot rate. The size of the pivot would probably deepen as the market assumed that the economic harm from higher rates would need to be addressed by greater cuts. Of course, if the Fed communicated the hiking cycle had a lot more to go, the curve would capitulate, but this is highly unlikely given we are teetering on the edge of a recession.

This has been the story all cycle. The Fed’s hawkishness was met by a higher expected peak rate, but that peak was brought forward, and the subsequent pivot made deeper. The market signally ignored the Fed’s evangelism for “higher for longer.”

Raising rates will increase the amount the Fed pays on reserve balances and on the RRP. This is great for larger banks who have a surfeit of reserves; it’s also good for money market funds and their clients (ZH: this is precisely what we have been warning about since last July).

But it means more stress for smaller banks who are not flush with reserves, some of which are still paying through the Fed’s target range for them. It will also at the margin further stress the hold-to-maturity portfolios of many, again smaller, banks. Moreover, it keeps pressure on rising interest-rate costs for the government.

Overall, if the next Fed hike was a trade for the central bank, it looks like one with poor risk-reward.

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