The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.
Consistent with consensus expectations, the US Federal Reserve (Fed) raised its benchmark interest rate by 25 basis points (bps), to a range of 5.00% – 5.25%, at its May policy meeting. Statements made during the Fed’s post-meeting press conference indicated that over the course of its next few meetings, the central bank would aim to pursue a more data-dependent approach to determining whether additional rate hikes would be necessary or appropriate.
While many Fed watchers had been hoping for a more unambiguous signal from the Fed that its rate-hiking campaign was now over, I interpreted Chair Jerome Powell’s comments as suggesting that the Fed may still have a slight bias toward maintaining higher policy rates as the central bank continues to assess the impact of recent banking sector stresses on US inflation and economic activity.
The leading economic indicators I track point to a likelihood of the US economy weakening substantially in the coming quarters. In particular, bank lending standards appear to have tightened materially in the wake of recent high-profile bank failures — a trend I expect to persist as many banks curtail lending and the lagged effects of the Fed’s rate hikes over the past year-plus work their way through the economy. While the steps taken thus far by the Fed and US banking regulators have helped restore market confidence to a large extent, the risk of further bank-deposit outflows remains acute.
From this perspective, given the potentially major impact of rising interest rates on the banking sector, I view yesterday’s additional rate increase by the Fed as having been a policy mistake — the consequences of which remain to be seen. JPMorgan Chase’s acquisition of First Republic Bank earlier this week may heal one wound in the system but could portend a dire fate for many other struggling US banks. For now, I have observed some stabilization in both bank deposits and commercial and industrial loans. However, the situation remains quite fluid and still bears very close monitoring in the period ahead.
In Chair Powell’s press conference, he alluded to the possibility that this current chapter in US economic history could be different from many previous periods. The Fed has raised its policy interest rate by 500 bps in a mere span of 14 months, yet the US unemployment rate hasn’t risen by all that much and, in fact, remains near its lowest level in 60 years. To Powell, the continued resilience of the labor market and the broader US economy seems to be evidence that a recession can likely be averted this time around. I tend to view that as hope winning out over experience and reality.
While the annual US headline inflation rate, as measured by the Consumer Price Index, dipped to 5.0% year over year in March (from 6.0% in February), the core inflation rate ticked up to 5.6% from 5.5%. Although the Fed anticipates that inflation will decline over the rest of this year, I think these latest inflation prints are still way too high for the central bank to consider cutting interest rates anytime soon.
Many leading indicators have inflation falling to around 3% by the end of 2023, a tad lower than the Fed’s projection when adjusting for weights in the Personal Consumption expenditures Index but still well above the Fed’s 2% inflation target. Importantly, US wages have decelerated a bit, which should help ease demand-pull inflationary pressures, but the labor market remains relatively tight, nonetheless.
While the market is now pricing in Fed rate cuts starting as early as the third quarter of this year, I suspect that may be wishful thinking. As of this writing, I believe the Fed has just reached its terminal policy rate and is now likely to go “on hold” for the foreseeable future — roughly a couple of quarters — so as to assess whether monetary policy is restrictive enough to keep cooling inflation without tipping the US economy into recession.
With its latest rate move, I think the Fed has given itself a degree of policy flexibility for the time being. If I’m right, its next action will be dictated by incoming inflation and labor market data, both of which could evolve in either direction, depending on how today’s big tail risks play out.
Expert
After the US downgrade: Thoughts on public debt, bond yields, and Fed policy
Continue readingURL References
Related Insights
Stay up to date with the latest market insights and our point of view.
Fed not yet willing to declare victory on inflation
We think the Fed is done raising rates for this cycle, despite the likelihood that they are being overly optimistic about inflation. Read to find out why.
Three themes (and what they mean) for income investors
With several macro crosscurrents at play, Portfolio Manager Peter Wilke suggests that income-oriented investors not lose sight of the “big picture” in their quest for yield.
US regional banking sector update
We explore how banking regulation and legislation could impact US regional banks, including highlighting the potential for M&A activity and for dispersion to drive long/short opportunities.
Financials amid rising dispersion
We explore why we believe dispersion across stocks, sectors, and geographies is supporting numerous secular themes in long/short investing in financials.
After the US downgrade: Thoughts on public debt, bond yields, and Fed policy
In the wake of the US debt downgrade by Fitch, Macro Strategist Juhi Dhawan explains what worries her most about the nation's debt situation and considers the impact on the term premium and the Fed’s plans.
Why cash won’t cut it for long: The case for bonds
Global Investment and Multi-Asset Strategist Nanette Abuhoff Jacobson and Investment Strategy Analyst Patrick Wattiau explore the relative potential benefits of bonds versus cash.
How to interpret the Bank of Japan’s latest policy shift
We analyse the wide-ranging investment implications of the Bank of Japan's latest policy shift.
Chair Powell maintains optionality
Fixed Income Analyst Caroline Casavant shares what she thinks matters most for investors in light of the latest interest-rate hike from the Fed.
Fed skips along the path to a pause
Jeremy Forster analyzes the Federal Reserve's decision to pause its interest-rate hiking cycle, explains why he believes it could be an extended pause, and shares the potential implications for fixed income markets.
Europe/US divergence: the ECB has further to go
How far will Europe diverge from the US? Macro Strategist Eoin O’Callaghan sees several reasons sustaining this growing divergence.
When the US sneezes, does the world still catch a cold?
Macro Strategist John Butler discusses the growing potential for cyclical and monetary policy divergence, despite markets pricing for the contrary, and assesses what it means for investors.
URL References
Related Insights