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Market isn't buying the Fed's 'higher for longer' message: Strategist

Bank of America Global Research U.S. Rates Strategy Head Mark Cabana joins Yahoo Finance Live to discuss the Fed's next policy move, inflation, the labor market, and the broader equity market.

Video Transcript

- Welcome back, everyone. Stock futures are lower as investors keep a close eye on economic data ahead of the Fed's December policy meeting later, as traders are debating the trajectory of Fed rate hikes. And joining us now on what might be in store for the markets in the year ahead, we've got Mark Cabana, who is the Bank of America Global Research Head of US Rates Strategy.

Things are a-buzzing over there on the floor. So tell us a little bit more about your thesis, particularly as we get into 2023. And particularly how it relates to the Fed. I mean, it's pretty much signaled that it's going to be a half a percentage hike at the next meeting.

MARK CABANA: That's right. Yeah. We do think 50 basis points at the next FOMC meeting in the middle of December. We think another 50 after that. And they'll conclude with a final 25 basis points at the March meeting.

So the terminal rate, we think, will be between 5 to 5 and 1/4. Now, this is slightly above where the market is priced. And we do think that the Fed has more work to do. We do expect. That the Fed is probably going to sound a bit more hawkish at the December FOMC meeting simply because we've seen financial conditions recently ease.

And the Fed's going to have a hard time lowering overall inflation while asset prices are rising. So we do expect that the Fed's going to send a little bit more hawkish in the near term. Very consistent with some, let's say, well-informed journalists who've recently been publishing something to a similar effect.

Now, we think that after the Fed gets to 5 and a 5-- to 5 to-- reaches 5 to 5 and 1/4, they're going to remain on hold for a considerable period of time. And we think that they'll probably start cutting rates in December of next year, as they see the overall economy moderate. They see signs that inflation is coming down. And they will also see signs, importantly, that the labor market is slowing, and they'll be seeing the unemployment rate. That'll give them confidence to proceed with those cuts.

Now, one of the challenges that the Fed has today is that the market is already well anticipating these cuts. The market is pricing in almost 170 or so basis points between the middle of 2023 and the end of 2024. And this type of rate cuts are somewhat unprecedented in terms of the history of Fed tightening cycles.

And it means that the market knows that the Fed's going to stop at some point-- let's call it between 5 to 5 and 1/2%, but then, they don't think that they're going to be on hold for all that long. And they're well anticipating the rate cuts. And that's really what's been driving the easing of financial conditions recently.

It's less about the terminal rate. It's more about the cuts that are priced.

- Oh, man.

MARK CABANA: And the Fed's going to have to push back on that notion if they, indeed, want to try and be successful on inflation in any material way. I know that was a lot--

- No.

MARK CABANA: --so I'll stop there.

- I mean, no. I'm saying, oh, man, because everybody's all about terminal rate, terminal rate, terminal rate. And you're saying now people are focusing on the cuts that are coming, once again. So it sounds like you think that scenario is incorrect. That if the markets are focusing on cuts that will be coming maybe even later next year, that-- and trying to price in, that that is a mistaken strategy.

MARK CABANA: Well, I think that it creates a real challenge for the Fed. Again, we expect those cuts, as well, as a research house. We think they are likely to happen. But if you're the Fed, the challenge that they have today is that they're trying to aim for a slightly lower terminal rate, and then, they're trying to say, no, no. We're going to be on hold for a long time.

Higher for longer is the narrative that they've been running with. The only problem is that the market doesn't see higher for longer as credible because they're pricing such a extreme amount of cuts after the Fed reaches terminal. So even though the Fed is saying higher for longer, the market is saying yeah, yeah, yeah. We know you're going to be cutting at some point. We trust that you're going to be cutting quite meaningfully.

And then, that's what's been easing financial conditions. So what does the Fed do? Well, they've got two choices, we think. Number one, they can try and more credibly convince the market that higher for longer will stick. They can do that, let's say, through the 2024 dot, in the summary of economic projections that they'll release in December.

Or they can do that by trying to provide some explicit forward guidance, saying that we will not cut rates unless the unemployment rate is at, let's say, 4 and 1/2, or inflation is 3 and 1/2 or lower, or something to that effect. That's how they can reinforce the higher for longer.

But if they're unwilling to do either one of those things, the only option that they have is to keep hiking rates. And that may mean that 5 to 5 and 1/4, as we think, is low. It could mean that they end up delivering something that's closer to, let's say, 6%. But this is the challenge that the Fed has today.

And again, it's rooted in the-- at the core, in the fact that they're probably not going to be able to get inflation to come down as long as financial conditions are easing, as long as asset prices are rising, and they've got to address this. Because right now, the market just thinks that the Fed is going to pause, and then, they're essentially done. And the Fed still has a lot more work to do.

- Well then, if that's the case, Mark, should someone fade any rallies in the broader equity market?

MARK CABANA: Look, we do think that this environment does create material headwinds for risk assets. The Fed's job is not yet done. And don't believe me. But just look at the wage data that we had on Friday. It's very strong.

The labor market is still extremely tight, and the Fed still has more work to do. Now, again, what the equity market, what broad markets have heard, and really wanted to hear from the Fed, is that, OK, they're done. The pivot's here. Powell, last week, didn't sound as hawkish that he-- as he had previously sounded. Therefore, it's OK to take risk.

And again, if you're the Fed, this is not the outcome that you need in order to really, credibly bring inflation lower. So again, we do think that the Fed is likely to deliver another dose of hawkishness at the December meeting. And we do think that that's going to create headwinds for risk assets. And maybe not make-- maybe not ensure that this particular equity rally has legs.

- And so, Mark put it all together for us from a strategy perspective. If risk assets maybe are getting walloped a little bit, where should people go? And particularly, if you can, through the lens of a retail investor and how they could-- could play this.

MARK CABANA: Sure. Well, so what we've been recommending on the interest rate side is that we've been suggesting that investors try and lean long duration. At least at the back end of the curve. And particularly, do so in a way that protects you from inflation.

We really like longer-dated TIPS here. We expect that longer-dated real rates are going to fall. And that all else equal, break-evens or inflation break-evens are going to be biased a little bit higher. We expect that long-dated real rates will fall simply because the economy is going to be slowing.

And there are good chances that the Fed, let's say, pivots before we see inflation back down to very close to 2%. We could see the Fed change their policy stance as inflation is falling. But the Fed might end up accepting a slightly higher overall level of inflation than they have in prior economic cycles. And as a result of that, we do think that break-evens or inflation you want to try and get some protection from.

And so we do think that being long real rates is a very attractive way to do that. So the TIPS market, and in particular at the back end of the rates curve, we do think is an attractive own for a whole host of investors. In particular, retail investors.

- Mark Cabana, Bank of America Global Research, Head of US Rates Strategy. Good to see you. Good. That-- good to see that trading room shot back, as well. We'll talk to you soon.