A focus for market participants is the outlook for short-term interest rates and FOMC guidance into 2023. There are market-based indicators that we monitor that can be helpful in tracking how the market is discounting probable outcomes related to short-term lending rates.
Overnight index swaps have increased over the last six months and recently moved above their highs in June. One-month overnight index swaps one year from now (USD OIS FWD Swap 1Y1M), two years from now (USD FWD Swap 2Y1M), and three years from now (USD OIS FWD Swap 3Y1M) made new cycle highs last week. However, the spreads between the 1Y1M against 2Y1M and 3Y1M have widened over the last six months as the 1Y1M moved up by more than the 2Y1M and 3Y1M. These spreads suggest higher short-term lending rates in the next year and a decline in rates thereafter. If the Fed were to change their guidance toward more rate hikes, we would expect these swaps to increase.
The Eurodollar futures curve is another way to track interest rate expectations. This curve would be upward sloping in a positive economic environment where the longer-term outlook for economic growth and inflation is more favorable than today. An inversion of this curve suggests longer-term prospects are less favorable, thus not conducive to more rate hikes. If the Fed were to take a more aggressive policy stance, the front-end of the curve would move higher and the current inversion would likely get pushed out further.
One of the reasons the FOMC may increase their outlook for rate hikes in 2023 is the economic measures of inflation like PCE and CPI remaining elevated. However, market-based inflation indicators are below their highs and have started to price in more normal levels of inflation. TIPS breakeven rates and inflation swaps can be used to capture the directionality of market-based inflation expectations. The 5-year and 10-year TIPS breakeven rates are both below their cycle highs. The 5-year breakeven is down 111 basis points from 3.73% in March, and the 10-year breakeven is down 54 basis points from 3.04% in April. Following the same path directionally, 5-year and 10-year inflation swaps are below their cycle highs. The 5-year inflation swap is down 82 basis points from 3.67% in March, and the 10-year inflation swap is down 50 basis points from 3.23% in April. For the Fed to use accelerating inflation as rational to increase its guidance for rate hikes, the direction of these market-based indicators would likely reverse course.
Outside of interest rate markets, Gold and equity sectors can provide a market-based signal on rate expectations. The price of Gold tends to rise when real rates fall and decreases when real rates increase. Gold is down 19% from its cycle peak on March 8th, as real rates have increased 263 basis points from their cycle low on March 8th. Gold has continued to make lower highs since April. If the market was pricing in lower real rates, this trend would reverse.
Equity sectors like Utilities and REITs tend to outperform in periods when rates are falling, and Financials tend to outperform when curves steepen. On a 3-month and 1-month trend basis, Utilities and REITs have underperformed and Financials have outperformed. In the month of October, yields have risen which has been a negative for Utilities and REITs and yield curves have steepened which has been a positive for Financials. If rates started to fall and curves started to flatten further, we would expect to see a reversal in the recent performance of Utilities, REITs, and Financials.
The next FOMC meeting where policy guidance will be released is December 14th. While we cannot predict the outcome of that meeting, we can continue monitoring these market-based indicators as that date approaches.
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Senior Economic Analyst
Boyd Watterson Asset Management, LLC