Hold for a Pause
I’ll resist the urge to declare, “That’s all folks,” because we never can be sure — but it sounded to me like this was the last rate hike. In a widely anticipated move, the Federal Open Market Committee (FOMC) raised its target rate by another 25 basis points to an upper bound of 5.25%.
That’s the 10th rate hike of this cycle, and perhaps concludes the fastest rate hike trajectory since the early 1980s.
Although this Fed statement was free from huge surprises, there was a notable shift that made many believe with more conviction we have now entered the “hold rates high” portion of the program.
Jerome Powell explicitly stated they removed the phrase that said, “anticipating additional policy firming may be appropriate” from this statement and replaced it with a phrase about taking various factors into account in determining whether additional firming may be appropriate.
That’s a lot of words that sound the same — but the main takeaway is that the word “anticipating” disappeared. There are multiple reasons the Fed could justify a pause at the next meeting, and in fact I think there were reasons they could have justified a pause at this one.
Perhaps one of the most quantifiable indications to pause is the Fed’s own preferred yield curve spread — called the near-term forward spread. It compares the current 3-month Treasury yield with the implied 3-month Treasury yield 18 months from now. If this measure is inverted, it implies that rates will be cut sometime in the next 18 months.
The near-term forward spread is currently inverted by 197 basis points. An inversion of this magnitude implies 90% recession odds in the next 12 months.
Of course, no measure is a perfect predictor, but if this is the Fed’s preferred yield spread, it’s signaling that conditions are sufficiently restrictive and does not send a “keep hiking” message.
Crises Are in the Eye of the Beholder
Mentions of the recent banking turmoil made numerous appearances in the statement, but they were alongside words like “sound and resilient.” There was some acknowledgement that the Fed did not foresee these events, and that they have contributed to further tightening of financial conditions.
Nevertheless, banking woes did not throw the FOMC off course as they’ve hiked rates twice since the height of uncertainty in mid-March. It’s possible that we’ve seen the worst of it, and perhaps the most recent bank failure was the last big one. But it’s difficult to calm investors’ nerves when we really don’t know what other risks are out there, if any.
It seems as though the Fed doesn’t view the recent stress as a crisis, but many investors are not convinced of the same.
Add to that uncertainty the looming debt ceiling debate that has a deadline on or around early June, which could fuel a volatility fire if one should ignite. Not to mention, the next Fed statement is on June 14, just days after this debate hits match point.
The obvious disconnect between how much gravity the Fed is assigning to some of these uncertainties and how much gravity the market is assigning to them gives me pause (no pun intended). Complacency has been a common thread in narratives for many months, perhaps this is another example of it.
I’m Rubber, You’re Glue
The most important disconnect that remains is the one between where the Fed sees rates at year-end, and where the market sees them. By the time the December meeting is complete, market probabilities suggest three rate cuts will have occurred. The Fed, on the other hand, suggested in its latest summary of economic projections and reiterated in this meeting, they do not plan to cut rates this year.
A disconnect this large is a recipe for volatility, IMO. And recipes for volatility can induce big market swings on small messages. Unfortunately, I think we are still in a period where the slightest bit of news can quickly change the direction of sentiment.
Furthermore, we’re still waiting for the full effect of this tightening cycle to be realized across the economy. Those effects are rarely subtle or smooth. An upcoming pause in rate hikes is not an indication the Fed is ready to start “normalizing” policy, I would view it more as an indication they acknowledge enough pain is being inflicted. Stay the cautious course.
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