By Eric Wallerstein, The Wall Street Journal, Nov. 1, 2022
Traders are betting higher interest rates will linger for the foreseeable future.
Ahead of the Federal Reserve’s next decision on Wednesday, derivatives markets show the federal-funds rate sitting at around 3.5% for the long run. That is a full percentage point higher than the central bank’s own latest forecast…
A longer-term transition to higher rates could mean weaker valuations for the tech sector, along with others where investors expect profits further down the road. …
The market bearing these interest-rate bets — the five-year, five-year overnight indexed swap rate — is set by market participants either hedging interest rate exposure or betting on where the fed-funds rate will be over the five-year period starting in five years, making it a useful gauge for the future path of Fed policy. …
Futures contracts tied to the policy rate now show fed funds peaking at about 5% around May or June 2023, and remaining lofty from there at around 4% by mid-2024. … Smaller rate increases from the Fed might not actually mark a pivot in policy, said Nomura managing director Charlie McElligott in a Monday note. The more important shift is “a lengthening-out of the hiking horizon,” he wrote…[end quote]
This forecast is a dramatic shift from only a few months ago, when the derivatives market predicted a much lower fed funds peak and a rapid pivot to falling rates.
Now traders are waking up to the reality that Fed policies take a long time to affect inflation so they will have to keep the fed funds rate high for a long time. Dropping the fed funds rate quickly will result in a resurgence of inflation that would be even harder to address.
If correct, this new forecast will affect both stocks and bonds.
Bond prices will continue to drop as interest rates rise. Inflation-adjusted bonds would yield less if and when inflation does fall.
Stocks would be strongly affected since the longer timeline will put pressure on zombie companies. The longer high rates persist the harder it will be for the zombies to roll over their debts and the more likely they will default. Tech company stocks may be especially hard-hit since their profits are expected in the future.
Bond buyers would be well-advised to target their purchases to mid-2023 and then ladder and/or go long.