As financial market gloom continued to deepen on last Friday, Deutsche Bank, Wall Street's most pessimistic bank, came out with yet another eye-opening view: Its U.S. economists, led by Matt Luzzetti, now expect the Federal Reserve to end its rate-hike campaign at 4.9% in 2023's first quarter.
The notion of an almost 5% fed-funds rate, which in Deutsche Bank's own words is "way beyond" what the market is pricing, comes just days ahead of the Fed's next meeting on Sept. 20-21 and as investors remain anxious about how high interest rates will have to go to tame the worst stretch of inflation in four decades. Investors were still trying to wrap their heads around the likelihood that the fed-funds rate target will likely rise above 4% by year-end, and the stock market sold off on last Friday -- fueled by a profit warning by FedEx Corp. $(FDX.AU)$, along with inflation and rate fears.
Few market participants have openly talked about the prospect of an almost 5% fed-funds rate target, essentially double the current level of 2.25% to 2.5%. Such a scenario could have an even more punishing effect on stocks than what's been predicted by billionaire investor and hedge-fund manager Ray Dalio, who estimates that a 4.5% level on rates would produce a 20% negative impact on equity prices.
Meanwhile, one key market rate -- the one-year Treasury yield -- hovered near 4% on last Friday, a development that some say could spill over into other rates and exacerbate worries throughout financial markets, in the U.S. and abroad.
Deutsche Bank's revised interest-rate forecast "is all about the inflation profile and how we expect inflation to remain at higher levels for longer," Luzzetti, chief U.S. economist, said via phone. "The Fed has always gotten the fed-funds rate target above inflation during all of its past tightening cycles, whether inflation was high or not."
"For policy to be restrictive, real or inflation-adjusted rates need to be positive and, right now, Fed officials can't rely on forecasts about inflation to decline over time," he told MarketWatch. "For them to have confidence, they need to get the fed-funds rate above inflation, at least by early next year," he said, although Deutsche Bank doesn't expect an almost 5% fed-funds rate to be sustained for very long.
Deutsche Bank's U.S. economists revised their expectations after Tuesday's unexpectedly hot consumer-price index report for August, and the upgrade is now closer to the 5% to 6% range that some at the bank think is needed to cool inflation.
Last Friday brought another downbeat day in financial markets, with all three major stock indexes finishing lower after trimming earlier heavy losses. FedEx's profit warning was being read by some, such as BNP Paribas Chief U.S. Economist Carl Riccadonna, as fitting into his view that a "massive deceleration" is under way for the U.S. economy.
Deutsche Bank was the first major Wall Street bank to call a U.S. recession in April. That same month, it went out further on a limb to say that it saw downside risk to its own pessimistic view. In June, Tim Wessel, a macro strategist, said he saw a chance that inflation fails to decelerate. And just three days ago, Henry Allen, a research analyst, said "that the pessimists will sadly prevail on this occasion" when it comes to the debate over whether the U.S. economy can achieve a soft landing.
On last Friday, Deutsche Bank was joined by Dutch financial-services company Rabobank, with another take on the prospect of higher-than-expected rates. Strategist Philip Marey said Rabobank now expects the fed-funds rate to peak at 5% next year, up from its prior forecast of 4.5%, given persistent inflation and a wage-price spiral that's already under way. Rabobank also doesn't expect the Fed to pivot from its rate stance before 2024.