Market Update

May 3, 2023

The Fed hikes rates by 25 bps

What’s important

• Today, the Federal Reserve (the Fed) unanimously raised the fed funds target rate by another 25 basis points (bps) to the 5.00% to 5.25% range while acknowledging that the stress in the banking system triggered by its previous rate increases is likely to weigh on the economy. This is the third consecutive meeting at which the Fed has hiked rates by 25 bps.

• The official statement from the Federal Open Market Committee (FOMC) deviated in several instances from its previous statement. Notably, language surrounding the pace of economic growth was toned down while reiterating that stress in the U.S. banking sector has weighed on economic activity.

• The largest change to the FOMC’s official statement was the removal of the phrase “The Committee anticipates that some additional policy firming may be appropriate” — it was replaced with more dovish phrasing, signaling that the FOMC will continue to monitor economic conditions to determine if further policy tightening would be appropriate.

• The FOMC did act unanimously — this was uncertain heading into the meeting, and public Fed commentary in the weeks leading up to the meeting started to display a small divergence for the first time this hiking cycle.

Fixed income

• The fixed income reaction to the Fed’s decision and Chairman Jerome Powell’s press conference was largely nonexistent. Across the curve, rates were basically unchanged, moving in each direction by less than 5 bps across the curve. This is perhaps not surprising, given how well the move had been telegraphed leading into the meeting. We’ve said that stress in the banking sector will continue to drive rates in the very near term, and Powell didn’t appear to say anything that deviated enough from Fed messaging to move markets during his press conference.


• 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). 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 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.

Equities

• Equities settled lower after a seesaw reaction immediately following the FOMC decision. The initial reaction was positive as investors focused on the statement’s omission of “additional firming may be appropriate,” signaling that a pause may now be the base case. However, at approximately 3:07 p.m. ET, that trend reversed as Powell remarked that the FOMC’s inflation outlook doesn’t support rate cuts. Equities stumbled, with the S&P 500 falling by nearly 1% from its intra-day peak, ending the session 0.7% lower for the day. The market reaction infers that investors had been hoping that Powell would communicate a firm rate pause with a bias toward preserving economic growth via potential cuts as opposed to potentially more tightening to combat inflation.


• 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.

Going forward

• The biggest takeaway from the Fed statements and press conference was that the FOMC believes that it’s at, or very near to, its terminal rate (the level at which the Fed is expected to stop raising interest rates). An underlying theme of the release and press conference was that those long and variable lags Powell has been referencing throughout the rate hiking cycle are starting to slow the economy. Be it tightening credit standards starting to make their mark on less lending or evidence that labor supply and demand are starting to align, helping to slow wage inflation, the real-world impacts of 500 bps of hikes are crystallizing. We believe that the data for inflation and jobs would have to remain high for inflation and/or strong in the jobs market for the Fed to raise rates by another 25 bps at its June meeting.


• 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 will likely hold them there until inflation starts rapidly moving closer to its 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 a 5%+ terminal rate, we expect pockets of volatility across equities and fixed income. We believe that the Fed will remain fully data dependent, as the most recent March 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 at its next meeting.