The market is reading the Fed wrong and policymakers look set to hold interest rates higher for longer to beat inflation, says Morgan Stanley's top fixed-income strategist
- Investors are incorrectly pricing in rate cuts in 2023, Morgan Stanley's chief fixed-income strategist said.
- The Fed looks set to hike rates to 5%-5.25% and hold them there as inflation runs above its 2% target.
Investors are mistakenly pricing in prospects that the Federal Reserve will cut interest rates in 2023, according to Morgan Stanley's chief fixed-income strategist Jim Caron.
"I think the market has it a little bit wrong here," he told Bloomberg TV in an interview on Wednesday. "What the forwards in the fed funds futures are telling us is that it's increasing the probability that there's going to be a recession at some point. That's why there's a downward slope," he said.
But with the central bank projecting inflation at 3.5% next year, higher than its 2% target, the Fed "needs to get this job done," he said.
"Unless something dramatic happens, all else being equal, I think the Fed is going to keep rates at the five, five and a quarter level, which is what they told us last week, and I think that they're going to hold it there," Caron said.
Investors were pricing in two more rate hikes in 2023 to 5% then cuts likely starting in November to accommodate a potential economic downturn. The 10-year Treasury yield has been falling on recession concerns, moving to 3.65% on Thursday from above 4% in October.
The Fed this month downshifted the size of its rate hike in December to 50 basis points from four consecutive increases of 75 basis points. But Chairman Jerome Powell maintained a hawkish tone, saying the bank needs to see "substantially more evidence" to determine if inflation was sustainably moving downward.
Major Wall Street banks and economists have been warning that the US is heading into a recession following the Fed's aggressive rate hikes – with seven in total this year bringing the fed funds rate from 0% to a range of 4.25% to 4.5%.
For markets, the first half of 2023 could deliver a recovery "surprise," he said. "And then the second half, we could see inflation not come down or not become anchored, and that could cause the Fed to get back into the game and start hiking rates," he said, adding that 2023 stands to be a " very confusing, pivotal year."
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