The path of least resistance for the Fed is to hike rates, says BofA’s Mark Cabana

[00:00:00] Speaker 1: Join us now. Mark Cabana, co-head of global rates research at Bank of America Securities. Are you surprised? Thanks for coming in, Mark. Are you surprised that 35 percent possibility of a rate hike? I would not have thought that, especially after the inflation readings. [00:00:19] Speaker 2: Well, thanks for having me. It's very unusual to be going into a Fed meeting with this level of uncertainty. The market has gotten used to a Fed that guided for its intentions coming out of a meeting. But to go in with roughly a one in three possibility that the Fed will be hiking versus holding is unusual. Now, if the Fed were to hike at this meeting, it would be, and this is not hyperbolic, unprecedented. According to our analysis, looking back to the early 90s for market pricing going into Fed hikes, we've never seen the market price less than a 60 percent probability of a Fed moving in that direction. So if the Fed were to hike today, it would be a big surprise and it would send a big signal about what this Fed's reaction function is to very elevated inflation. Now, Joe, to your question, is it surprising that the market is still hanging on to this to some extent, because the data that we have gotten since the Fed last met in June has indicated a better than expected outlook for inflation, at least a softer than expected June inflation print in a labor report that was not as strong as many had anticipated. However, the market is still believing in this possibility because we've heard hawkish discussion from some Fed members, and we've heard Chair Warsh indicate that he really has to some extent an impatience on elevated inflation. And so those dynamics, we think, are what is giving the market this relatively elevated risk that the Fed could surprise with a hike today. [00:01:57] Speaker 1: We have no history of Warsh. There's a new sheriff in town. Would he want to prove? I just can't see it. Would he want to prove there's a new sheriff in town and I'm here and do that? Because... [00:02:10] Speaker 3: Well, if you want to prove you've got a bazooka in your pocket, you don't want to have to... [00:02:13] Speaker 1: You talk with a bazooka in your pocket. [00:02:15] Speaker 3: But maybe you shoot off one quick shot so everyone knows you got it. [00:02:18] Speaker 2: So the argument... I think that would be a big mistake. The argument for it... I think it happened. The argument for it is that he has sounded so impatient on getting inflation down. And in his congressional testimony, he said there's been... It's been 62 months, five years, since the Fed last hit its inflation target. So they've been failing for a long time. And the longer that he would wait to potentially act, the more he owns it. Right now, he can somewhat inflation blame the last Fed chair, Powell, for this issue. [00:02:49] Speaker 3: Yeah, he doesn't hold any responsibility for where it stands for the last five years. [00:02:53] Speaker 2: That's right. [00:02:53] Speaker 3: I did hear somebody on Morgan's show this morning describe, pretty interestingly, that to your point, Joe, we're still trying to figure out who Kevin Walsh will be as chairman. And one of her guests said, we don't know if he has a hawk in dove's clothing or a dove in hawk's clothing. And I thought that was a pretty good description. [00:03:09] Speaker 2: Look, the last time I was in this seat where you had me on just ahead of the June FOMC, I think I made a comment saying that Kevin Walsh is a relative stranger to financial markets. I still think that's true. We don't know what his reaction function is yet. He has talked tough on inflation, but we don't know if he's going to back that up yet. Now, Joe, when you were doing the rundown of current interest rates, I noticed you paused a little when you talked about the 30-year. It's back above 5%. It has been for a little while now. And a lot of the questions that we get are, how does the long end of the rates curve respond if the Fed hikes? Do long end rates go up or do they go down? And we think that the answer to that is really a function of how the market interprets a Fed hike in relation to the outlook for growth and how risk assets respond. My own personal view is that if the Fed hikes today, it'll be a surprise. The market will likely dial back its growth expectations ever so modestly. And risk assets probably won't like it. The combination of modestly lower growth and risk off, I would think, helps bring long end rates down to some extent as opposed to push them meaningfully higher. We'll have to see if that's exactly what happens. But if your Fed share warsh and you're asking yourself, how do I surprise today or why would I surprise today? To establish that credibility on inflation is one reason. But also maybe to help long end rates come down is another. And we know that that is an objective for this administration. [00:04:44] Speaker 1: He knows that these spoiled brats, they're already pouting that they're not going to get cuts because they had that. I mean, OK, so we're not going to get any cuts. And you can watch the way Bitcoin acts or whatever or, you know, wait a minute. No, no, no, no cuts. So then we go to, you know, no neutral or no action at all. The idea that you'd go all the way, make two steps, that's like an analyst going from a strong buy to a strong sell. [00:05:10] Speaker 2: That never happens. It would be a surprise. And there's many in at least the equity space that I speak with that almost think it's impossible that this could happen. I know, right. And you think two descents, you think two people will want to hike. We do. Ten to two. And when we think about the composition, we do think you'll get two descents if they hold. But notably, if they hike, we actually think you'll get zero descents. How many total? Twelve. Twelve. Ten to two, then, is what you think. So it's notable that the path of least resistance, just from a descent perspective, would indicate a hike at this meeting, not a hold. Now, that's not necessarily how Warsh is going to manage things. He's going to do fundamentally what he thinks is in the best interest of the U.S. economy. But the path of least resistance for the Fed is to hike.