Post Fed Thoughts
The Federal Open Market Committee (FOMC) announced a 25 basis points hike in its meeting yesterday, as expected, bringing the upper bound of the target policy rate to 5.25%, which is the highest level since 2007. The Fed also maintained its monthly pace of shrinking its balance sheet by $60bn for Treasuries and $35bn for MBS, and the decision was unanimous. The phrase “some additional policy firming may be appropriate” was dropped from the Fed’s statement. The hawkish commentary from the Fed continues despite building stresses in the system, highlighting higher-than-desired inflation, labor-market strength, and tightening credit conditions as factors that it will be monitoring for future policy decisions.
The Fed highlighted higher-than-desired inflation, labor-market strength, and tightening credit conditions as factors that it will be monitoring to make future policy decisions. This puts the Fed in a very data-dependent position going forward, and all eyes will be on the non-farm payroll number on Friday and next week’s CPI and PPI data.
Chairman Powell was questioned about the current market pricing of rate cuts in 2023, and he cautioned that the FOMC is not expecting inflation to come down that quickly, and rate cuts would not be appropriate, hence why it is not in their forecast. Fed futures are now pricing in 80 plus basis points of cuts by year-end, but the market does not seem to be taking his comments seriously, with interest rates sitting at the lower end of the recent range. The significant negative spreads on two and five year U.S. Treasuries to current Fed Funds indicate that the market is significantly ahead of the Fed in terms of easing.
We were surprised by Powell’s confidence in his statement that “avoiding a recession is, in my view, more likely than having a recession”. This ongoing confidence in a soft landing seems to be in direct conflict with current markets. Not surprising was Chairman Powell’s focus on the conditions in the banking sector. Chairman Powell’s comments that things have “broadly improved” since March also seemed to conflict with the price action in the markets and the growing concerns around regional banks. Chairman Powell raised the issue that the Senior Lending Survey (SLOOS), released next week, as likely to show significant tightening in credit, which could put additional pressure on growth.
In our opinion, Chairman Powell’s comments did not inspire confidence, and the focus on lessons learned is concerning. This is especially concerning with the stress building in the banking system. We were also grabbed by his ongoing comments that ‘maybe it is different this time’ but not explaining his position. This reinforces our growing concern with the wide band of outcomes that could play out in the near term. While the Fed is happy to see some progress, it is still concerned about the tight labor markets and higher levels of inflation. The Fed remains firm and not wavering off the 2 percent inflation target, a target that seems far out on the horizon. We believe that the tightening of credit in the system is a growing issue, as credit creation is the foundation of incremental economic growth. Lastly, Chairman Powell’s repeated emphasis on taking a “data dependent” approach means the central bank has abandoned the idea, at least for now, of providing investors with explicit forward guidance, making each data point a trigger for greater volatility.
In our eyes, it would have been reassuring if the large regional banks rallied post Chairman Powell’s comments, but this has not been the case so far. We are paying very close attention to the growing negative sentiment that is building here and question when the Fed will be more proactive in calming the markets.
Overall, the FOMC meeting indicates that market observers will be closely watching economic data releases in the coming weeks to gauge the direction of future policy decisions. This likely brings with it greater volatility in the rates markets and some additional uncertainty in the credit markets. Our experience of this earnings season to date further raises the issue around higher volatility in front of us. While it is obvious that the economic growth outlook is slowing, it is less clear that inflationary pressures are receding at a pace that gives the Fed comfort. If we do not see a continued decline in the inflation data, we would expect even greater volatility in front rates and a market that is vulnerable to quick repricing.
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