The market’s expectation is that the Federal Reserve will keep lifting its policy interest rate until it brings it to 5% before pausing for some time.

But it’s possible that the Fed could decide that 5% is not nearly enough. That would be the case if the U.S. economy continues growing at a solid clip and inflation doesn’t substantially cool off.

Strategists at JPMorgan led by Nikolaos Panigirtzoglou decided to examine a scenario in which the Fed would take its benchmark rate to 6.5% during the second half of 2023. They noted that the JPMorgan economics team assigns a 28% likelihood to that scenario, so it’s within the realm of possibility, even though the rates market only assigns a 10% probability to that outcome.

In discussions with clients, the strategists said, that scenario is widely perceived as the Armageddon scenario. “After all, the last time the Fed funds rate was at 6.5% was in 2000 and that level of policy rates was followed by very heavy losses for risk markets at the time,” they said.

But the JPMorgan team wouldn’t expect actual Armageddon to take place in financial markets. “In our opinion, while there is little doubt that [Fed rates at 6.5%] would be negative for most asset classes including equities, bonds and credit, the eventual downside is likely to be more limited that an Armageddon would suggest,” they said.

Net debit balances in NYSE margin accounts are at low levels.

Finra/NYSE/JPMorgan

Demand for bonds, the strategists noted, has already collapsed, and it’s expected to remain weak as central banks engage in quantitative tightening. “This unprecedentedly weak demand projected for 2023 raises the hurdle that demand would post another big negative surprise in 2023 and increases the risk of an upward surprise,” they said. Plus, supply is forecast to drop by $1.7 trillion next year.

Granted, the Fed taking rates to 6.5% would have big implications on the short end TMUBMUSD02Y, 4.319% of the Treasury yield curve. But yields on the longer end would rise “by a lot less,” they said, implying an even starker inversion than what we’re seeing now.

They made similar comments on the U.S. stock market, based on Commodity Futures Trading Commission data on leveraged funds and asset manager positioning. “All these equity demand indicators stand at rather low levels, creating an asymmetric backdrop where another big decline seems a lot less likely for 2023,” the analysts said.

Already, they noted, the S&P 500 SPX, +0.75% has been basically unchanged over the last seven months, even as the peak in Fed pricing has climbed to 5% from around 3% in May.

Source: finance.yahoo.com