(Bloomberg) - Traders wagering this week on the Federal Reserve lifting its benchmark interest rate to 6% are still aiming way too low, according to Dominique Dwor-Frecaut.
Dwor-Frecaut, a senior market strategist at the research firm Macro Hive, says the Fed will have to boost the federal funds rate to about 8% to win its battle to bring inflation fully under control. That’s based on her analysis using a Taylor Rule model with data stretching back to 1970.
She’s not fazed by the fact that her call is still very much an outlier. She first made this prediction not long after the Fed started its tightening cycle in March 2022. For traders, she warns that two-year Treasury yields are headed well above 6%, and the yield curve will become even more inverted than it is now.
“I’m even more confident about my 8% call after the nonfarm payrolls report,” Dwor-Frecaut, who previously worked in the New York Fed’s markets group, said in a telephone interview, referring to surprisingly-strong employment data published on Feb. 3. “The funds rate has to go much higher than is now predicted. Policy is still very easy.”
While Dwor-Frecaut may be in a minority on Wall Street, others have floated similar ideas. Former Fed Presidents Jeffrey Lacker and Charles Plosser wrote in a recent Wall Street Journal opinion piece that, if inflation stays where it is now, typical policy rules would recommend a rate between 6.5% and 8% by the end of the year.
For now, though, overnight index swaps are priced for a peak in the federal funds rate of about 5.1% in July, and then cuts to around 4.8% to close out 2023. The hot jobs report brought market pricing for the so-called terminal rate in line with Fed officials’ own estimates: In December, they published projections suggesting they expected to raise the federal funds rate to 5.1% this year, according to the median estimate, though they didn’t see any rate cuts until 2024.
New York Fed President John Williams said on Wednesday that those numbers still seem reasonable. Currently, the federal funds rate is about 4.6% — up from nearly zero at the start of 2022.
The December projections also showed policymakers saw inflation falling to 3.1% by the end of 2023 — though at the expense of higher unemployment, which they saw rising to 4.6% as tighter monetary policy took its toll on the economy.
But the unexpected surge in hiring in January sent the unemployment rate to 3.4%, the lowest level since 1969. That’s something Dwor-Frecaut warns isn’t going to reverse course until interest rates are much higher.
“We will have low unemployment and higher inflation than the Fed’s predicting,” she said.
Dwor-Frecaut expects a harsh recession — and potentially a financial crisis — in 2024 will ultimately force the Fed to reverse course. After moderating in recent months, core inflation is set to rebound as China’s economy reopens and energy prices move higher, filtering into prices of other goods and services, she says.
Two-year Treasury yields hover now at about 4.4%. The yield premium over the 10-year note is now 85 basis points, and the inversion has room to run, according to Dwor-Frecaut. The gap reached over 200 basis points in the early 1980s, amid harsh tightening by then-Fed Chairman Paul Volcker to tame the high inflation of the era.
Read More: Treasury Yield-Curve Inversion Reaches Deepest Level Since 1980s
“If I’m correct on inflation and the Fed’s policy rate, it’s going to be an enormous shock for the market,” Dwor-Frecaut said. “So, I see potential for much deeper inversion. Two-year yields will move much higher. Getting beyond 6% is easy.”
By Liz Capo McCormick
With assistance from Rich Miller
