by Mark Keller, CFA, Bill O’Grady, and Patrick Fearon-Hernandez, CFA | PDF
In our 2022 Outlook: The Year of Fat Tails, we outlined a forecast with a higher likelihood of events outside the norm. To compensate for the unusual level of uncertainty, we promised to provide frequent updates to the forecast. This report is the first of the year. One of our contentions in the forecast was that the FOMC would not raise interest rates this year. In light of developments, this position is untenable. Therefore, in this update, we will discuss four potential outcomes from the upcoming rate hike cycle and the potential effects on financial markets.
Over the past three months, we have seen a dramatic shift in expectations surrounding monetary policy. One way to observe them is by the behavior of the two-year deferred three-month Eurodollar futures implied yields.
In early November, the deferred Eurodollar futures were projecting steady policy for the next two years. In a mere three months, we have seen a rapid shift to nearly four rate hikes of 25 bps each. Although similar shifts have occurred in the past, we note that when such shifts occur, the likelihood of recession does increase.
With tighter monetary policy looming, we would argue there are four likely terminal paths. They are as follows:
- Path #1: Policy is rapidly tightened, leading to a recession.
- Path #2: Policy is tightened too slowly, causing a debasement crisis.
- Path #3: Policy tightening triggers a financial crisis, leading to a rapid easing of policy.
- Path #4: A soft landing occurs.