A Different Kind of Pivot

Markets hoped for a dovish Federal Reserve “pivot,” but got a hawkish surprise instead. Brace for more volatility as the yield curve adjusts, warns Franklin Templeton Fixed Income CIO Sonal Desai. She sees the fixed income outlook as more constructive moving further forward in 2023.

After the November 1-2 Federal Open Market Committee meeting, markets must have wondered if Federal Reserve (Fed) Chair Jerome Powell dressed as the Grinch this Halloween.

Financial markets went into this November Fed meeting hoping for a “pivot,” a signal that after today’s expected 75 basis point (bps) hike the Fed would switch to a few smaller rate moves, then pause, and sometime next year start cutting rates again. Markets were convinced this would validate the drop in bond yields that took place last week, and turn it into the beginning of a steady decline. A fairly rosy and constructive scenario.

Powell snatched it away.

Asked about the December meeting, he left a glimmer of hope, saying we could see another 75 bps move or a smaller one, depending on the data. At this point of the press conference, market moves made it clear investors thought he was opening the door to a smaller hike.

Then came the cold shower—more like an ice-cold waterfall. Don’t think about the pace of hikes, said Powell—what matters now is how high rates go. They will go higher than the Fed previously thought, he said, and they will stay higher for longer—it’s very premature to even think about a pause. The Fed has not done nearly enough yet, he added. Inflation is still way too high and core inflation shows no sign of coming down. And the Fed is not worried about overtightening—policymakers know how to correct that if it happens. He said the Fed worries—a lot—about not tightening enough (or cutting too soon) because then inflation will become really entrenched.

All this confirms my long-standing view that the policy rate will go higher than markets think, it will stay higher for longer, and investors should not expect rate cuts in 2023. I got the distinct impression that Powell does not want to pause until he’s comfortable that the policy rate is high enough—he does not want to pause and then have to resume hiking because inflation still does not come down. He wants to err on the high side.