July 26, 2023
The Fed hikes rates by 25 bps
The Federal Reserve (the Fed) today unanimously voted to raise the policy rate by 25 basis points (bps), bringing the fed funds target rate to 5.25%–5.50%. We believe the theme of a still-hawkish Fed that’s laser focused on bringing inflation down to its 2% target remains intact, as Chairman Jerome Powell reiterated that many times at his press conference.
The official statement by the Federal Open Market Committee (FOMC) was almost entirely unchanged, with the biggest difference being a change in verbiage to reflect the fact that the policy rate is being raised by 25 bps.
The only other change to the official statement was very minor but potentially important to note. The statement changed one word when describing the expansion of economic activity — from “modest” to “moderate” — potentially signaling that growth is more resilient than the FOMC thought in past meetings.
- Rates markets were largely unchanged during the meeting, perhaps not surprising given the telegraphed rate increase as well as the lack of Summary of Economic Projections. Powell gave thoughtful answers to the questions at the press conference, but he avoided giving rates markets any particular short-term guidance for rate hikes. Rates were anywhere from 0 to 4 bps lower across the U.S. Treasury yield curve since the press conference began, which to us doesn’t feel like a meaningful or conclusive move.
- We remain defensive in our credit positioning and are moving to a very modest duration extension relative to the benchmark. We favor higher in credit quality (as we expect credit spreads to leak wider on the expected economic weakness). We advocate shifting from cash to the two- to five-year area of the U.S. yield curve in order to take advantage of potential price appreciation as well as locking in an attractive carry yield in advance of broadly declining rates. Within tax-exempt markets, we believe that 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.
- No news was treated as “no news,” with equities shrugging off today’s rate decision and settling near the same level as when Powell began his press conference, with performance for the day dominated by the micro effects of the corporate reporting season as opposed to any macro developments. The lack of market reaction to the Fed appears congruent with Powell’s insistence on data dependency, effectively reducing the efficacy of forward guidance, which had been a primary transmission mechanism for monetary policy in the past. This should increase the impact and frequency of macro data on equities moving forward.
- Going forward, we flag the risk that Fed policy may remain tighter for longer as stress in the banking system looms, while a restrictive monetary stance continues to weigh on economic growth. In our view, this would support a focus on defensive growth, quality and profitability outside of mega-cap leadership.
- The biggest takeaway is probably that the Fed isn’t convinced June’s inflation reading is a sustained trend just yet. If Powell’s goal was to not spook markets and to maintain the Fed’s data dependency, his press conference accomplished that in our view. We felt he did a good job of continuing to maintain a hawkish posture despite inflationary data that’s moving closer to the Fed’s 2% target. The September meeting should be a critical one, not so much in relation to raising rates but in terms of clueing us in to how the FOMC interprets two months of inflation and labor data.
- We believe that the Fed now has rates high enough to fight inflation, as policy rates are at a sufficiently restrictive level and the Fed has indicated that it will likely hold them there until inflation starts rapidly moving closer to the Fed’s 2% target. While June’s inflation data showed that inflation is slowing materially, the Fed’s preferred measure of core services inflation (excluding housing) was up slightly as compared to May. Looking at longer-term trends, it’s moving in the right direction closer to the Fed’s target.
- As markets further struggle with a 5%+ terminal rate (the level at which the Fed is expected to stop raising interest rates), we expect pockets of volatility across equities and fixed income. We believe that the Fed will remain fully data dependent, and Powell reiterated that many times during his press conference. Between now and the September meeting, the Fed will have a lot of economic data to help it make its next decision on whether to continue hiking rates or pause. If the data consistently continues to move closer to the Fed’s 2% inflation target, that will give the Fed leeway to potentially pause rate hikes.
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