Could the Fed funds rate hit 5%?

On the latest edition of Market Week in Review, Chief Investment Strategist Erik Ristuben and Investment Strategy Analyst BeiChen Lin discussed recent rate hikes by the Reserve Bank of Australia (RBA) and the Bank of Canada (BoC). They also chatted about the U.S. employment report for November and its potential implications on interest rates.

Could the Bank of Canada pause its rate-hiking campaign soon?

Lin opened the segment by noting that both the RBA and the BoC lifted borrowing costs the week of Dec. 5, with the RBA opting for a 0.25% increase in its cash rate, while the BoC hiked its benchmark rate by 0.50%.

Ristuben said that Australia and Canada are in similar situations, with both nations battling high inflation and the impacts of rising rates on their housing markets. He explained that the mortgage structures in both countries are somewhat similar, consisting of either variable rates or shorter fixing periods, which makes mortgage rates in Australia and Canada reset on a much more frequent basis. As a result, both countries are far more sensitive to rate increases than the U.S., where the most common type of mortgage structure is a 30-year fixed rate mortgage, Ristuben noted.

“This puts both the RBA and the BoC in a tricky spot, because each has to walk a very fine line when it comes to raising rates. On the one hand, both banks know that rate increases are needed to help tame inflation, but on the other hand, neither wants to raise rates to a level that could potentially cause real damage to the housing market,” Ristuben observed.

In his opinion, the RBA probably has a little more room to increase borrowing costs, with its cash rate now at 3.1%. The BoC, meanwhile, will probably pause on rate hikes, Ristuben said, noting that the central bank’s benchmark rate currently stands at 4.25% after its latest increase. 

U.S. labor market remains robust

Shifting to the U.S., Lin noted that the Federal Reserve (Fed) is also expected to raise interest rates soon, with markets anticipating a 0.50% increase in the overnight rate at the conclusion of the central bank’s Dec. 13-14 meeting. Ristuben said that one of the key factors the Fed will be assessing ahead of its decision is the state of the U.S. labor market, which has remained surprisingly robust this year.

The latest example of the labor market’s strength was the November nonfarm payrolls report, which showed that 263,000 jobs were added last month, he said—significantly above consensus expectations. In a world where good news for Main Street is bad news for Wall Street, markets unsurprisingly reacted poorly to the report, Ristuben noted, with the S&P 500® Index off 2.6% the week of Dec. 5, as of market close on Dec. 8. Markets in Canada and Europe were also rattled by the U.S. jobs number, he added, with investors beginning to wonder if the peak federal funds rate will end up higher than anticipated—perhaps at 5.0% or just a touch shy.

“The problem here is that, in order for the Fed to really be confident it’s crushed inflation, the supply-and-demand dynamic in the labor market needs to be reset—which means, at the very least, the Fed needs to see fewer job openings. But there are still over 10 million job openings in the U.S., and with the unemployment rate staying steady in the 3.5%-to-3.7% range over the past several months, it’s clear the U.S. is at full employment,” Ristuben observed. This puts upward pressure on wages, with U.S. wages up 6.5% in November on a year-over-year basis, he said.

“Even though this is a slightly lower wage-inflation number than what we saw in October, 6.5% is still far too hot for the Fed to be comfortable,” Ristuben stated. He said that in order for the Fed to really slow—and potentially pause—its rate-hiking campaign, significant improvements in wage pressures are needed.

However, he and the team of Russell Investments strategists believe that wage pressures are unlikely to slow enough over the next few months to allow the Fed to go on pause. “Ultimately, in our view, this makes a U.S. recession in 2023 more likely than not,” Ristuben concluded, adding that the full details on the strategist team’s outlook for the year ahead can be found in the recently released 2023 Global Market Outlook.

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