The Fed’s pause was hawkish, so what does that mean for markets?

Market Update

The equity market continued its rally in a busy week for central banks. Cooler U.S. inflation and a pause by the Fed drove U.S. equities to a fresh 14-month high. Notably, the tech-heavy Nasdaq 100 index is now only 10% below its pandemic peak in 2021. The rates market traded sideways on the week with 10-year Treasury yields staying above 3.8%. Following Chair Powell’s press conference, the Treasury curve bear-flattened with a deeper inversion led by higher front-end yields.

Elsewhere in the market, China’s central bank cut one of its key policy rates, and sentiment on Chinese equities improved slightly on this move. All eyes are now on Beijing with reports of policymakers preparing additional stimulus measures. May activity data missed expectations, pointing to the need for more policy easing. We nonetheless note that monetary conditions are not restrictive in any sense, and any easing measures will need to address the low level of confidence and currently weak aggregate demand. These are relatively novel problems, and it’s not clear how effective the tools in Beijing’s policy toolkit will be. We continue to remain below consensus and expect a gradual economic recovery in China. For investors, market pricing has largely adjusted to take this weaker outlook into account and we now see more upside than downside risk. 

Strategy Question: The Fed’s pause was hawkish, so what does that mean for markets?

Fed recap

In a move that was largely expected, the Fed hit the pause button, holding its target policy rate steady at 5.0% - 5.25%. This marks the first time since early 2022 that the Federal Open Market Committee (FOMC) voted to leave rates unchanged. Markets largely took the move in stride; U.S. equities were unchanged, while the 10-year Treasury yield lost 3bps to 3.79%. While the move was arguably dovish in that there was no hike, the outcome of the meeting was decidedly hawkish, somewhat surprisingly so.

Heading into today’s meeting, most expected just one final hike to follow yesterday’s “skip.” But policymakers indicated two more hikes could be in store through some subtle but important changes to the meeting’s statement. Of particular note, changes to the Summary of Economic Projections (SEP) were more hawkish than anticipated. The median dot rose by 50bps, bringing the new terminal rate expectation to 5.6%, and core PCE inflation was revised several tenths higher to just under 4%. Although Chair Powell created optionality for the timing of future rate hikes, he clearly indicated that July is a "live" meeting.

The changes suggest more rate hikes are likely ahead, as opposed to more hikes being possible.   

If more hikes are needed, why pause now?

The economy is still difficult to read and the Fed wants another month of data before deciding if more hikes are warranted. Chair Powell reiterated that the lags between monetary policy and its impact on the economy are long and variable. Consumers and corporates have healthy balance sheets (especially compared to the 2008 crisis) and many of them have locked in broadly lower financing costs during the era of ultra-low interest rates during the pandemic. This may be making the economy slightly less rate-sensitive due to less variable rate debt on household balance sheets, but that simply means rate hikes could take more time and more could be needed. With policy rates at their highest since 2007, growth momentum is waning – housing, capex, and consumer delinquency data are all showing signs of slowing. But the Fed is not yet confident inflation is falling fast enough.

What does the market think?

Rates pricing suggests the market does not believe the Fed – and thinks no more hikes are coming. The below chart shows that the terminal rate did not move up at all from the levels seen prior to the meeting, despite the Fed telling us they intend to hike at least one more time. What did change is the market priced out any cuts this year, expecting rates to stay unchanged until at least early 2024. In this respect the market is more in line with the Fed, though still not fully believing the Fed’s projected rates path. The long-term path moved higher, with the market believing the Fed will keep rates elevated or above the neutral rate through 2025. However, if the Fed follows through on its projection, rates will have to reprice higher along the curve.

If the economy is slowing and inflation is trending in the right direction, why would the Fed need to hike more?

It’s all about inflation. It may be cooling, but it’s still too high – especially the core measure, which strips out volatile food and energy prices. Chair Powell and the Fed are focused on three big components to crack inflation: core goods, rent, and core services ex-rent (popularized in the media recently as his “super-core” read). Core goods inflation appears to be under control after a spike in 2021 and 2022. Shelter remains elevated but is expected to continue decelerating as indicated by forward-looking market rent data. That puts the focus on “super core” inflation. There was encouraging news on Powell’s “super-core” measure, which increased just 0.2% last month and is down to a 3% annualized rate in the three months to May. However, it is important to recognize that this measure is being distorted by declines in volatile items like airfares and medical services that carry less of a signal for monetary policy. The stickiest part of inflation, most tied to wages, and hence relevant for gauging risks of inflation getting entrenched, is core services less shelter, health insurance and air fares – and this gained 0.4% m/m, or double the “super-core” measure.

This is what the Fed is focused on and why they remain concerned that more hikes will likely be needed. One needs to get into the weeds of the inflation data to understand the Fed’s concerns, but to summarize, falling health insurance prices have been a very large deflationary force over the past year. This alone has subtracted around 1.2ppts from measured inflation, most of it just since December. If you look at a “super-core” measure stripping this out, core services inflation ex rent and health insurance is still running at a 4.5% rate over the past three months, and health insurance could very well start increasing soon after the long correction. Let’s also not forget that the Fed targets core PCE, not CPI, which has shown less moderation than CPI due to computational issues, and less housing, has remained sticky above 4%.

It is still far from clear that rates are restrictive enough to bring inflation sustainably back to 2%, particularly with wages still growing strongly (see below). This is why the Fed has signaled further hikes.

Investment implications

For markets, yields are likely to continue holding high in the short term, and the curve is likely to continue its deep inversion led by high front-end yields. We are still expecting one additional hike in July, but the Fed's latest projections introduce upside risk. However, we think the lagged impacts of tightening will eventually flow through the economy. It is likely lead to a significant slowdown around the end of this year or going into the first half of 2024. Overall, we think the Fed appears to be close to finishing its hiking cycle, even if there is incrementally more hawkishness. One of our top investment recommendations remains core fixed income. Investors should be aware of growing reinvestment risk, as yields are likely to be lower going further forward rather than higher, as the economy continues to cool – though the timing of this is impossible to predict. Extending duration during this time could also help to provide a buffer when a slowdown does occur and yields go lower. In light of still-resilient data and an uncertain outlook, diversification and active management remain key to capturing alpha opportunities in risk markets, while protecting against a potentially deeper slowdown.

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