Executive summary
As widely expected by markets, the Federal Reserve (Fed) raised interest rates by a quarter point (0.25%) and left the pace of its balance sheet runoff—known as quantitative tightening (QT)—unchanged.
Chair Jerome Powell’s tone was definitively neutral during the post-meeting press conference, walking a tightrope between hawkishness and dovishness. He deftly weaved positive and negative points into his responses to questions with the goal of creating maximum policy flexibility for upcoming policy decisions. If he was trying to be vague about future moves – either a hike, a pause, or an eventual rate cut – mission accomplished.
Though a shallow recession remains our base case, the chances of a so-called soft landing are now closer to 40%. Yet, “no recession” translates into higher rates for longer, which is increasingly restrictive and could hasten a slowdown in the economy.
While the Fed will eventually cut rates at some future date, the timing remains a moving target given the multitude of economic crosscurrents and market distortions. At this point, there’s simply no definitive change in trend to justify cuts. We view speculation about when a Fed rate cut might occur as premature, especially given today’s emphasis on data-dependency.
What happened
At its July rate-setting meeting, the Federal Open Market Committee (FOMC)
unanimously agreed to increase its target range for the federal funds rate by a quarter point (0.25%) to a range of 5.25% to 5.50%. This was the 11th increase, taking the target rate up 5.25% in the past 17 months from essentially zero.
Chair Powell started the post-meeting press conference by underscoring the Fed’s dual mandate of pursuing maximum employment and price stability. He highlighted both stronger economic data and the cumulative impact of tighter credit conditions and how the latter will continue to slow economic activity.
Chair Powell was also extremely explicit in maintaining the Fed’s flexibility to do what is necessary based on how the economy performs. Moreover, he added that, there was “no use in providing guidance on hiking or cutting” at this point. He also clearly stated that he wouldn’t provide numerical guidance regarding an inflation threshold for what it would take to begin cutting rates.
Yet, Chair Powell revealed that the Federal Reserve’s staff economists – which are separate from the FOMC and present data and scenarios to the committee – are no longer forecasting a recession. Equity markets immediately reacted to that statement, giving back some modest gains achieved during Powell’s press conference.
Our take
In our view, the Fed is clearly struggling with lingering too long or cutting too soon. We maintain our view that Fed policy is being guided by scar tissue - from prematurely loosening policy in the past. This informs our view that the Fed will hold rates higher for longer and likely lingering too long.
We acknowledge that resilience in the economy has increased the probability that the U.S. could skirt a recession – a so-called soft landing. At the beginning of this year, we said a soft landing had less than a 10% chance. Now, that chance is essentially 40% – dramatically higher but still not our base case. In essence, there are a wider range of outcomes due to many crosscurrents, which is among the reasons why we said “stay flexible” in the ’23 outlook.
To be clear, there are many interpretations of a soft landing. Our view is a soft landing could be a quarter or two of negative gross domestic product (GDP) but without job loss or a meaningful rise in the unemployment rate (an increase of greater than 0.5%). That’s what occurred in the first half of 2022. Or several other scenarios, including a rolling sector recession – whereby industries contract but are not synched up – allowing the overall economy to skirt. For instance, housing crashed in ’22 but has rebounded this year, while transportation slowed earlier this year, and manufacturing is contracting now, etc.
At this point, the fourth quarter of this year will likely post negative GDP, if for no other reason than the restarting of student loan payments. Inflation has clearly peaked and is moving lower but remains much hotter than anyone is (or should be) comfortable with. Based on today’s rate hike and no guidance for what it will do next, evidently the Fed is in this camp, too.
Bond market reaction
Today’s move was well-telegraphed, paving the way for a muted reaction post-announcement. Chair Powell projected a high level of flexibility to future rate decisions is reduced rate volatility, giving traders little forward guidance for repositioning.
In the immediate aftermath of today’s Fed rate decision, U.S. Treasury yields declined across most of the curve by 0.01% to 0.06%. The modest drop in 2-year U.S. Treasury yields suggest traders largely view that today’s rate hike will be the Fed’s last of this cycle and that policy is sufficiently restrictive to tame inflation. Fed funds futures reflect a similar shift; however, the market is still split over whether the Fed will deliver one more 0.25% rate hike before year-end.
Despite the 10-year yield falling to 3.85%, the 2-year/10-year yield curve remains deeply inverted by roughly -1.0%. This inversion expresses the fixed income market’s ongoing concern that slower U.S. economic growth is likely on the horizon. The lagged impact of the Fed’s actions over the past 18 months is still emerging. We expect tighter lending and credit conditions to further weigh on economic activity and inflation, creating downward pressure in U.S. Treasury yields. Thus, we reiterate our stance that current intermediate yield levels present a tactical opportunity to add duration in fixed income portfolios that remain short of their intermediate benchmark. Expectations for decelerating domestic economic growth support our emphasis on high quality fixed income, which tends to outperform riskier fixed income sectors in such an environment. Current credit spreads – particularly in the high yield sector – insufficiently compensate investors for downshifting growth alongside a Fed regime that remains steadfast in its mission to curb inflation.
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