Fed hikes once more with a pause on the horizon

The Federal Reserve hiked the Fed Funds rate by 25bps at its May FOMC meeting, bringing the target rate up to 5.25% on the top end. The move came in line with our expectations, as well as the markets, and we believe marks the end of the Fed’s hiking cycle. Since it began raising rates in March 2022, the Fed has hiked 10 times for a total of 500bps of monetary tightening in little more than a year, its largest and fastest pace of interest rate hikes since the high inflation period of the 1970s and early 1980s.

The 25bps hike was widely priced in by markets so focus fell more on the Fed’s commentary and particularly how it is assessing the stress in the US financial system. The FOMC removed its line that “additional policy firming” could be needed that it introduced at the March FOMC and watered it down to take into account the “cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity…and economic and financial developments.” The further shift away from forward guidance was backed up by commentary from Fed chair Jerome Powell in his press conference after the FOMC decision was released, saying the Fed no long “anticipated” the need to hike further.

In his press commentary, chair Powell stated again that the strains in the financial system were equivalent to a tightening of policy in excess of the Fed’s rate hikes and quantitative tightening and noted that policy was “tight.” But he also indicated that the data flow needed to show whether or not the current level of rates at 5.25% was restrictive enough, leaving room to perhaps hike again if needed at upcoming meetings. Powell also remained optimistic on the chances for the US to avoid a recession, noting the strong demand in labour markets and the drop in job openings not coinciding with an increase in the unemployment rate.

Our baseline view on USD rates is that they have now reached their peak and that the Fed will hold them stable for the remainder of the year. Inflation, while it has come down from peak levels reached in mid-2022, is still well above the Fed’s target levels. The PCE deflator at 4.2% y/y is still twice as high as the Fed’s target level and core PCE, stripping out volatile prices like energy, has been stickier at around 4.5%-5% since Q2 2022. Our year-end target for the Fed Funds rate on the upper bound remains 5.25%.

There are risks to this outlook. If conditions in the US economy deteriorated substantially—a major increase in the unemployment rate or a sharp recession developing over the next two quarters—then the Fed would likely need to adjust policy to a more accommodative stance. The rapid pace of rate hikes has also prompted substantial stress in the financial system in the US, particularly among institutions whose business models were based on rates remaining low in perpetuity. The collapse of several mid to large regional banks will tighten credit conditions as others are forced to improve their own liquidity. Regional banks are also highly exposed to the commercial real state market in the US which may lead to more asset/liability mismatches and a further pullback on credit availability. Should stress in the financial system spread, then the Fed would likely need to rapidly switch to an accommodative policy stance and deploy emergency tools.

That is not our present expectation for the US economy even if activity this year is still set to slow substantially and border on recession-like conditions. The Fed also appears to be working under the assumption that issues around the US federal debt ceiling will be resolved.

Markets are pricing in an early turn from the Fed—as near as the July FOMC—when rate cuts are tentatively priced in. The bias toward accommodative policy in markets will mean a barrier for Treasury yields to have to push through. Yields may hold close to current ranges—with the 2yr oscillating around 3.75-4.00%--before a stronger catalyst, in the form of a weaker US economy, starts to bring them steadily lower toward the end of the year.