Economic Commentary

Executive summary

The Federal Reserve (Fed) policymakers held the federal funds rate unchanged. As widely expected, the committee slowed balance sheet runoff, though all of the reduction was for Treasury securities. 

During the press conference, Chair Jerome Powell’s tone and comments were markedly pragmatic and flexible – not overly hawkish or dovish. Markets seemed to breathe a sigh of relief as yields retraced and stocks climbed, at least initially. 

Ultimately, Fed policy continues in a holding pattern, pushing rate cuts out further this year. Yet, given where key components such as housing are trending, we believe that progress on inflation should allow for at least one rate cut before the end of the year.

What happened

At its May rate-setting meeting, the Federal Open Market Committee (FOMC) unanimously agreed to leave its target range for the federal funds rate in a range of 5.25% to 5.50%. That's the sixth consecutive meeting without a change.

As expected, the Fed slowed the pace of its balance sheet runoff (i.e., quantitative tightening, or QT) to $60 billion per month beginning in June from $95 billion currently. However, the monthly redemption cap on Treasury securities dropped to $25 billion from $60 billion, while the agency mortgage‑backed securities (MBS) remained at $35 billion. Moreover, any MBS principal payments in excess of that cap will be reinvested into Treasury securities.

During the press conference, Chair Powell was rather pragmatic, highlighting both the economy’s resilience and acknowledging that the progress towards reducing inflation had stalled recently. On the latter point, he flatly stated that “gaining greater confidence that inflation is trending lower will take longer.”

Powell pointedly noted that it’s unlikely that the next rate move would be a hike. He also specifically called out not wanting to upend liquidity for money markets nor incite financial market turmoil. Regarding the threat of stagflation, Powell said, “I don’t see the stag or the flation” as growth has remained solid, and inflation has come down sharply from peak levels, though it’s not all the way down to the committee’s 2% target.

Powell also strongly swatted away the requisite question about, “how much does the election factor into the committee’s timing of policy changes?” He noted that this will be his fourth election cycle during this Fed tenure and at no point had elections ever been discussed.

Our Take

Once again, Chair Powell did what he needed to do; this time, alleviating investors’ worries that the Fed was growing increasingly hawkish. Given a ton of data showing a stronger-for-longer economy and a commensurate stickiness in inflation recently, the Fed really didn’t have much of a choice at this meeting other than staying on hold.

Regarding slowing QT, the downshift in the pace is notable insofar as it was all on the Treasury securities side. Furthermore, the MBS hasn’t been near the $35 billion monthly redemption cap for quite some time. In fact, MBS has been running at roughly $17 billion for the past year and averaging just $14 billion for the past 3 months. 

Bond market reaction
U.S. Treasury yields have marched higher since the start of the year as traders recalibrated for sticky inflation data, resilient consumer activity, and a longer-than-anticipated Fed rate pause. A great deal of expected Fed hawkishness was priced into the yield curve over the past four months. However, some key developments within the rate announcement today still projected a slight sense of dovishness relative to market expectations. For one, the statement maintained that the next move for the Fed funds rate is still much more likely to be a rate cut than a rate hike. Additionally, Fed officials’ decision to sharply slow the pace of its monthly balance sheet run-off will also contribute to a slightly less restrictive policy stance. As a result, U.S. Treasury yields declined in the immediate aftermath of the decision. The 2-year U.S. Treasury yield initially fell roughly 3 basis points (0.03%) from the trading day’s starting point to 5.00%. The 10-year U.S. Treasury yield declined 4 basis points (0.04%) to 4.64%.

There was a notable reaction to Powell’s comments that it is “unlikely” that another rate hike would be necessary to cool inflation. Yields across the curve effectively doubled their decline (i.e., higher prices), with the 10-year dropping to 4.58% before grinding a bit higher. The 2-year held on to its decline. Given our expectation that growth and inflation will continue to moderate in the quarters to come, we still expect the Fed to execute its first rate cut later this year. However, recent inflation readings lower the probability of the Fed being able to move forward at the June meeting. Currently, Fed funds futures project just one 0.25% cut this year, a dramatic shift from the almost 7 cuts the market expected back in January.

Despite some hotter-than-anticipated inflation readings in recent months, Powell dismissed the idea of raising rates again. This reinforces our view that yields in the front end of the curve peaked in October. For those seeking high quality, passive income with more constrained interest rate sensitivity, yields in the front end of the curve (i.e., U.S. Treasury bills out to 2-year maturities) present a compelling opportunity.

In our latest House Views publication (April 22, 2024), we upgraded our view of duration to more favorable considering the sharp increase in intermediate yields over the past several months. The upgrade reflects two key developments. First, the improved income generation that provides a powerful offset to rising yield environments and a meaningful contribution to total returns. Secondly, we expect downward yield pressure (i.e., positive price performance) in high quality fixed income as economic growth slows as we progress through this year, helping cool inflation, and easing monetary policy. However, we note that upside inflation surprises, federal deficit concerns, and rapid government debt issuance pose challenges to our view.

Bottom line

The Fed remains in a holding pattern for the next several months but progress on inflation should allow for at least one rate cut before the end of the year. That would ease financing pressures on consumers and businesses alike, keeping the economy growing.