June 14, 2023
Fed Pauses Rate Hikes
The Federal Reserve (the Fed) today unanimously voted to leave the Fed funds target rate unchanged, and it will remain at 5.00% to 5.25%. Despite today’s pause in rate hikes, we believe the theme of a still-hawkish Fed that is laser focused on bringing inflation down to its 2% target remains intact.
The Federal Open Market Committee’s (FOMC) official statement was largely unchanged from the May meeting, with the biggest difference simply being stylistic changes to reflect the fact that they are pausing instead of hiking rates. Comments in the official statement specifically regarding the economic outlook were unchanged.
- The biggest surprise of the meeting was the release of the Summary of Economic Projections (SEP), specifically the dot plot. The median dot for the Fed funds target rate rose to 5.6% by the end of 2023, an increase of 50 basis points (bps) over the previous SEP released in March. This implies that two more 25-bp hikes are likely to occur this year.
- The release of the hawkish dot plot provided a brief surprise moment for fixed income markets and was the impetus for an immediate sharp reaction upward in interest rates. The 2-year U.S. Treasury yield jumped as high as 4.78% immediately after the release of the SEP, before settling down to a 4.70% to 4.75% range during Fed Chairman Jerome Powell’s press conference. This move in yields would have been less drastic if not for the SEP. The 10-year U.S. Treasury yield had a similar reaction, jumping about 5 bps after the release of the SEP, but it too has settled down — as of this writing, it is roughly unchanged on the day.
- We remain defensive in our credit positioning and are extending duration very slightly. We favor higher in credit quality (as we expect credit spreads to leak wider on the expected economic weakness). Take advantage of higher rates, particularly in the short end of the yield curve, by using U.S. Treasury Bill rolls. 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 bucked their trend by first reacting unfavorably to the release of the Committee’s official statement before recovering most of the decline during the Fed Chairman Powell’s press conference. This contrasts with past meetings of which Powell has presided, during which stocks have tended to decline during the question-and-answer portion. As a rate pause was widely expected, traders were keen to analyze the forecasts in the SEP. Initial interpretations were hawkish as inflation estimates from the FOMC moved higher, and the estimate for Fed funds target rate increased. Investors also seemed to be buoyed by Powell’s confidence that a “soft landing,” where we avoid a recession, can be achieved even if policy may remain tighter for longer than previously expected.
- 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 growth, profitability and quality factors.
- This meeting felt a bit chaotic, given the dichotomy between the pause but a surprising shift higher in the SEP Fed funds target rate projections. We believe it’s best to look beyond the noise of today and see a Fed that is still strongly committed to fighting inflation — one that will now likely deliver two more rate hikes, and one that is not looking to cut rates anytime soon. In his press conference, Powell made it clear that the bias at the Fed remains heavily tilted toward fighting inflation, even if that comes at the expense of weaker economic growth through tighter credit conditions.
- We do believe 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 is likely to hold them there until inflation starts rapidly moving closer to the Fed’s 2% target. While May’s inflation data showed inflation is slowing overall, the Fed’s preferred measure of core services inflation minus housing continued to accelerate in May and that led the Fed to indicate more rate hikes are on the way if this continues.
- 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 the Fed will remain fully data dependent, and today’s pause gives the Fed time to analyze the upcoming June inflation and employment data. Markets will be closely monitoring future data releases too, as those will help guide whether the Fed raises rates again or takes a pause during its July meeting.
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