Oh, what a night: FOMC meeting leaves more questions than answers

After a historic FOMC meeting when the Federal Reserve announced that it will “pause” its rate hiking cycle, the immediate market reaction has been one of confusion. US stocks managed to edge higher, while 2-year US Treasury yields, although volatile earlier, are basically unchanged on the day after spiking 13 basis points when the Fed’s rate decision was first announced. We believe that the market remains unclear about when or if another rate hike will take place, as the criteria for such a hike was not made clear during Wednesday’s meeting. The market is pricing in more rate hikes from the Fed, there is now a 64.5% chance of a 25bp rate hike to 5.25-5.5% at the Fed’s next meeting in July. Expectations for rate cuts in the second half of the year have also been lowered. The market now expects 2 rate cuts by the end of January 2024, one week ago there was a 34% chance of three rate cuts by January, today that probability has dropped to a mere 22%. 

The Fed has taken a risky path, while there has been progress on inflation in recent months, the headline rate of price growth is now 4%, while the core rate of inflation has fallen to 5.3%, price growth is still well above the Fed’s target rate. Thus, the risk remains that the Fed may have to reverse course quickly and start to hike rates again, as we have seen with the Canadian and Australian central banks in recent weeks. Overall, with stress in the commercial property market bubbling away, memories of March’s bank collapses and consumer credit growth running high, the Federal Reserve is showing some sympathy with the plight of many American consumers and businesses by slowing the pace of rate hikes at this stage.

Upgraded expectations

However, the Fed see this move as a skip, rather than a pause, something that we mentioned in our previous note. Most Fed members expect to vote for future rate hikes later this year. The Fed’s interest rate projections for 1 year were revised up to 4.6% from 4.3%, and in two years’ time, the Fed expects rates to be at 3.4%, compared with 3.1% in March. Current rate projections are 5.6%, up from 5.1% in March. Thus, the pain for interest rate sensitive areas of the economy, including the mortgage market, lending and commercial real estate could be here to stay. It is worth noting that the Fed’s longer-term expectation for rate increases was unchanged at 2.5%.

Growth, growth, growth

Why didn’t markets freak out at this upgrade for interest rates on Wednesday night? In our view it is because the Fed also upgraded their forecasts for growth and inflation. This suggests that the economy can grow even with stubborn inflation levels, which suggests that the Fed still believes that firms have pricing power, and that consumers can consume even though the economic backdrop is challenging. The Fed’s median expectation for GDP this year is now 1% vs. 0.4% in March, for 2024 it is now 1.1% vs. 1.2% in March, and for 2025 it is 1.8% vs. 1.9% in March. Although there has a slight downgrade in future GDP, no recession is expected even with higher rates. Inflation is expected to continue to rise this year and fallback at a slightly slower pace in the long term. The Fed’s median core PCE expectation for 2023 is 3.9% vs. 3.6% in March, for 2024 it is unchanged at 2.6%, and in 2025 it was upgraded a notch to 2.2% vs. 2.1% in March. What strikes us is that inflation is not expected to reach the Fed’s target rate in a 2-year time horizon, and with recent stickiness in core inflation, the risk to these forecasts is to the upside.

The Fed’s soft landing could become a reality

The Fed also expects the labour market to remain, their median projection for the unemployment rate this year is 4.1% from 4.5% in March, and the unemployment rate is only expected to rise to 4.5% in 2-years. This leads to questions about the effectiveness of monetary policy on the economy: 10 consecutive rate hikes, the fastest pace of hikes in more than 40-years, has not been particularly helpful at bringing down inflation or weighing on the labour market. Either this is the perfect “sweet spot” for rates, and the Fed will navigate the soft economic landing in this monetary policy cycle, or there is a recession coming that the Fed can’t see.

The sensitive stage of the monetary policy cycle

While some argue that Federal Reserve Chairman Jerome Powell was hawkish during his press conference, I detected a slight change in tone. He ended it by saying that he understood that the Fed’s actions affect individuals, businesses, and families, and that everything the Fed does is in “service to our public mission”, which is to provide full employment and stable levels of inflation. Right now, they have the former, but not the latter. To achieve the latter the FOMC judge that they need to hike interest rates further, and we think that Powell is sounding apologetic for that. While that may not impact what the Fed does in the future, his sensitive tone could put investors at ease about the Fed’s next steps. If the Fed cares about the economy, then they may not shock the market with future rate hikes in the way of the Bank of Canada or the Reserve Bank of Australia.

The dollar on the backfoot

The dollar took the brunt of the selling pressure, and it weakened by 0.28% on a broad basis on Wednesday. The dollar index has been trending lower this week and is down more than 1% in the last 7 days. In early post-Fed trading, the mini sell off in the buck is continuing. We believe that there is the potential for more volatility before the end of the week, as the market fully digests the Fed’s confusing message and decides what this means for markets. Overall, for now, we are not overtly bearish on US stocks, and we think that the dollar could struggle further before it turns a corner.

What the Fed means for other central banks

The ECB is expected to hike rates on Thursday to 3.5% from 3.25%, and we expect them to signal that further rate hikes are likely. We will also be watching the UK rates market on Thursday, to see if the Fed’s latest move will influence expectations ahead of next week’s BOE meeting that comes amidst rising pressure on the UK’s mortgage market.