Market Update

March 22, 2023

Fed Hikes Rates By Another 25 bps

What’s important

• The Federal Reserve (the Fed) today unanimously raised the Fed Funds Target Rate another 25 basis points (bps) to 4.75%–5.00% while acknowledging that problems in the banking system triggered by its previous rate increases are likely to weigh on the economy. This is the second consecutive meeting in which the Fed has hiked 25 bps. In short, with today’s additional hike, rates remain well into restrictive territory to help slow inflation.

• The 25-bp hike was due to consistently sticky services sector inflation, in addition to a labor market that continues to be stronger than the Fed would like. Inflation data in advance of the meeting showed deceleration of inflation from the previous month but still well above the Fed’s 2.0% annualized target.

• The Federal Open Market Committee’s (FOMC) official statement deviated from the previous month, striking a reference to “ongoing increases in the target range will be appropriate” and replacing it with “some additional policy firming may be appropriate” — a dovish pivot in our view.

• The official statement also added language around the current state of the banking system. The FOMC feels that “the U.S. banking system is sound and resilient. Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring and inflation. The extent of these effects is uncertain.”

Fixed income

• Fixed income markets rallied on the initial announcement of the Fed’s decision and followed through after Powell’s press conference. As of this writing, the 2-year U.S. Treasury Yield has rallied by more than 20 bps, below the 4% level, while the 10-year U.S. Treasury Yield rallied by 15 bps, below 3.45%, reducing the spread between the 2-year U.S. Treasury Yield and the 10-year U.S. Treasury Yield to 75 bps. The longer end reaction was more muted, with the 30-year U.S. Treasury Yield falling 5 bps.


• 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). 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

• Equities have been whipsawed over the past few weeks, having at one point anticipated a stronger commitment to a tighter policy stance upon Fed Chair Powell’s testimony on Capitol Hill, to a very much expected dovish outcome at today’s meeting, given the stress in the banking system.


• Stocks were relatively flat heading into today’s decisions and moved slightly higher upon a dovish interpretation of the Summary of Economic Projections, which indicated the Committee’s expectations for higher inflation with lower unemployment than previously expected. However, market positioning did shift a bit upon the Fed Chair’s question-and-answer session. Powell pushed back on the probability of rate cuts, and he acknowledged the likelihood that demand will need to weaken to contain non-shelter service inflation. Stocks stumbled lower, with cyclical segments most prone to declines while growth-oriented Technology remained more supported.


• 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 slow growth. In our view, this would support a focus on growth, profitability and quality factors.

Going forward

• The biggest takeaway from the Fed statements and press conference was that the FOMC believes that tighter lending standards will ultimately act as a substitute for, or even exacerbate rate hikes. The Fed did say that the banking system is resilient, and we believe them. Furthermore, banks are better capitalized and there are more tools at policymakers’ disposal to keep bank and financial markets stabilized. This gives us confidence that while volatility in the banking sector will remain elevated, there are tools to help mitigate any further risks to financial stability.


• 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. Services are keeping inflation sticky, and once we see a meaningful decline in the services sector, that will help bring the overall headline inflation data down, but we won’t see that until later this year.


• As markets further struggle with the possibility of a 5% terminal rate, we expect pockets of volatility across equities and fixed income. We believe the Fed will remain data dependent, as the recent February inflation report shows that inflation is starting to ease. Markets will be closely monitoring future data releases, as those will help guide whether the Fed raises rates again or takes a pause in its next meeting.