Fixed income perspective – from the Investment Advisory Group

Fixed Income Perspectives

July 27, 2022

Fed maintains singular focus on inflation fight

Executive summary

  • The Federal Open Market Committee (FOMC) raised the fed funds rate by 0.75% to a target range of 2.25-2.50% in a unanimous vote.
  • The latest FOMC statement acknowledges the weaker trends emerging in spending and production activity, while highlighting the labor market’s strength over the past several months.
  • Chair Powell warned the Fed’s forward guidance about policy changes are likely to become less clear, a shift that increases the Fed’s flexibility but reduces transparency.
  • Immediately following the decision, the U.S. Treasury curve steepened as Chair Powell stated the policy rate had reached a neutral setting and future hikes were not set in stone.
  • With a meaningful lag existing between policy changes and their economic impact, the Fed’s inflation fight will further weigh on economic activity in the months ahead.

What happened

At its July rate-setting meeting, the Federal Open Market Committee (FOMC) agreed to increase its target range for the federal funds rate by three-quarters of a point (0.75%) to a range of 2.25% to 2.50%. This is the fourth rate increase in the current tightening cycle and the Fed’s second consecutive 0.75% hike. Before the June FOMC meeting, the last time the Fed delivered a 0.75% increase was in 1994.

Notably, the FOMC statement acknowledged that spending and production activity has slowed significantly since the previous rate decision. However, the Fed’s concerns over these slowdowns are mitigated by resilient aggregate demand and ongoing strength in the U.S. labor market.

In his post-meeting press conference, Fed Chair Jerome Powell emphasized two key themes. First, Fed officials are still extremely focused on tightening monetary policy to “moderately” restrictive levels to bring demand back in balance with available supply and cool inflation. Secondly, he signaled the Fed’s forward guidance will likely become less transparent going forward and the size of future rate increases will depend on how economic data evolves. Chair Powell also stated that he does not believe the U.S. economy is currently in a recession, pointing to strong job growth and rising wages as meaningful bright spots that are inconsistent with fears over an imminent recession.

Our take

While an oversimplification, it is useful to look at the U.S. Treasury yield curve in three distinct segments and analyze the primary forces driving their behavior. Within this framework, we can piece together how the yield curve will likely evolve through the rest of the year.

The first 12 months – This region of the yield curve largely reflects Fed rate policy in real time given its short-investment horizon. While the Fed discussions have intensified around raising the Fed funds rate to combat strong inflation, the Fed has only raised its policy rate by 75 basis points (0.75%) to a range of 0.75-1.00%. As a result, yields in the very front end of the curve remain suppressed. As the Fed executes additional hikes throughout the rest of this year, we expect short yields to extend their rise.

The Fed’s second consecutive super-sized rate hike likely takes the fed funds rate to a level close to a “neutral” setting – one that the Fed believes should neither slow nor accelerate the U.S. economy over the long-term. We expect the Fed will continue to raise its benchmark rate to roughly 3.25-3.50% between now and year end. This is a level consistent with the Fed’s goal to increase the policy rate to a moderately restrictive setting.

The Fed is probably eager to raise rates at a slower pace over the next few meetings, but that will require softer incoming inflation data. However, monetary policy is well known to work with a delay. The impact of the central bank’s rate hikes so far this year will take time to seep into the system and reveal their ultimate impact. Thus, the aggressive tightening strategy thrust upon the U.S. economy by the Fed will contribute to more economic challenges and uncertainty that are already on the rise.

In an effort to maintain ample policy flexibility, the Fed is doubling down on its pledge to remain wholly data-dependent going forward. Simultaneously, it is warning that policymakers’ forward guidance (i.e., what it plans to do next) will be less clear for meetings ahead. In an effort to avoid a market tantrum, the Fed has been very careful to plainly state its policy intentions and build a long runway before their execution. But today’s uncertain and fast-evolving economic conditions are making it very difficult for the Fed to successfully telegraph policy.

This likely has two key implications. For one, the Fed may be less beholden to its projected tightening path on a meeting-to-meeting basis. This should add helpful pages of data-dependency and nimbleness to the central bank’s playbook. And two, financial markets may exude higher volatility around future monetary policy decisions with less clarity provided ahead of time.

For example, Chair Powell mentioned that as of the June meeting, Fed officials roughly expected the fed funds rate to reach 3.25-3.50% by the end of this year and 0.25-0.50% additional increases in 2023. Currently, the market is not following this path. There is strong agreement with the Fed’s rate projections through the end of this year; however, fed funds futures trading shows the market consensus expects rate cuts will arrive around the middle of next year. In other words, either the Fed’s economic expectations from their June FOMC meeting are too sanguine on the economy or market participants are too pessimistic. Regardless, this divergence raises the risk of policy blindsides that tend to fuel periods of elevated volatility.  

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