Market Update

February 1, 2023

Fed Continues Rate Hikes in 2023

What’s important

• Today the Federal Reserve (the Fed) unanimously raised the Fed Funds Target Rate by 25 basis points (bps) to the 4.50%–4.75% range in a move that was well telegraphed by the Fed and anticipated by the markets. In short, with today’s additional hike, rates are now well into restrictive territory to help slow inflation.

• Today’s rate hike represents a downshift from December’s 50-bp move and is 50 bps less than the four consecutive 75-bp hikes in 2022. We predict that the Fed isn’t done hiking. We expect two additional 25-bp hikes, a move Chairman Jerome Powell strongly alluded to in his press conference.

• The Federal Open Market Committee’s official statement changed slightly to note that inflation has eased somewhat but remains elevated. Additionally, the statement removed language stating that the global health crisis as well as food and energy were contributors to inflation. Critically, the phrase “ongoing increases in the target range will be appropriate” was retained in this meeting’s official press release.

Fixed income

• Fixed income markets rallied significantly on Powell’s disinflation comments, despite being largely unchanged during the initial announcement of the Fed’s decision, and language in the official statement noted that additional rate hikes would be appropriate. As of this writing, the 10-year has rallied through the 3.40% level, only the second such breach of this level since September 2022.


• We remain defensive in our credit positioning, with neutral duration relative to the benchmark and higher in credit quality (as we expect credit spreads to leak wider on the expected economic weakness). Within tax-exempt markets, we believe essential service municipals are better positioned for an economic downturn. We prefer active fixed income portfolio management and fundamental credit selection will offer opportunities in these volatile times.

Equities

• Equities were relatively tame into and immediately following the Fed’s rate hike announcement, with the real action taking place during Powell’s press conference. Equities initially traded lower as Powell’s prepared remarks appeared hawkish. However, approximately four minutes into the press conference, equities reversed their trend, with the S&P 500 erasing losses and surging more than 2% from trough to peak. Price reaction seems to reinforce the notion that investors are more focused on weaker inflation, limiting the hawkishness of policymakers as opposed to concern regarding the economic growth outlook.


• In our view, the risk to equities remains tilted to the downside as corporate fundamentals grapple with slowing pricing power, stalling unit growth and compressing margins. Meanwhile, higher rates improve the relative value of other yield-based assets. Given the unusual distribution of effects from slowing growth and inflation across segments, we favor a nuanced approach with exposure to sources of quality, yield and growth at a reasonable value.

Going forward

• With today’s 25-bp increase, the Fed reiterated its view that policy must be “sufficiently restrictive to return inflation to 2 percent over time.” During the press conference, Powell stated firmly and plainly several times that the Fed’s job isn’t done and that the Fed has a while to go in order to bring inflation back down to its 2% target. While markets continue to worry that future Fed hikes will significantly hurt economic growth, the Fed continues to prioritize slowing inflation over economic growth, which will lead to longer-run economic sustainability.


• We do believe in the Fed’s commitment to fighting inflation by moving policy rates to a sufficiently restrictive level and holding them there until inflation starts rapidly moving closer to the Fed’s 2% target. Our view continues to be a 5%+ terminal rate (the level at which the Fed is expected to stop raising interest rates) by the first half of 2023. Although the market is at odds with this view, we do expect capitulation eventually as the market fully digests the stark reality of a 5% terminal rate for longer and still-strong labor market.


• As markets struggle with the possibility of a 5% terminal rate, we expect pockets of volatility across equities and fixed income. We continue to believe markets will remain data dependent, as the recent December inflation report shows that inflation is starting to ease, and markets will closely monitor future data releases, as those will help guide the Fed in the magnitude and duration of future rate hikes.