The Federal Reserve again raised policy rates by 75bps, now to a range of 2.25%-2.50%. We think its hiking path will be slower from here, although we disagree with market pricing that suggests rate cuts as soon as next year.
We believe investors should avoid getting ahead of themselves and expect continued volatility, adding exposure selectively on a sector and security basis.
From zero to “neutral” in just four months
Rates are now at the Fed’s median projection of the long-term "neutral" rate at 2.5%. This is a remarkable turnaround, “expeditious” in Chair Powell’s own words, considering they were at the zero-bound just four months ago.
As such, we believe further hikes this year will likely be of lower magnitude. While we almost assuredly have not seen the peak in rates, we have potentially seen peak hawkishness. Markets currently expect a 50bp hike at the next meeting in September. From there, we currently expect only 25bp hikes at most at subsequent meetings this year. We expect policy rates to peak at ~3.75%.
Figure 1: The Fed is rapidly catching up to policy rates implied by the Taylor Rule1
Peak hawkishness does not mean imminent dovishness
Markets are currently projecting rate cuts next year. We disagree with the markets here, and see rate cuts as a long way off as we expect inflation to remain high above 5% until at least Q2 2023. Chairman Powell made clear in his press conference today that bringing down inflation is the Fed’s clear, overriding priority.
The market appears to consider recession risks as a reason for future rate cuts. However, the Fed’s aim is to slow growth and normalize frothy financial conditions, so achieving those goals (in and of themselves) is unlikely to be enough to spark rate cuts in our view.
Further, although recession is a risk, we do not see it as a done deal. Economic conditions are starting from a strong position. Indeed, Powell emphasized the need to slow growth from its too-hot pace. For example, although rate hikes have helped slow the housing market, home sales are still consistent with pre-pandemic levels (Figure 2).
Figure 2: Existing home sales have fallen, but are still at pre-pandemic levels2
Similar can be said for consumer balance sheets. Although much as been made of recent reported upticks in credit card delinquencies over the last year, these comparisons are being made against this time last year, when many consumers received $1,400 stimulus checks. Delinquencies are still solidly lower today than they were pre-pandemic (Figure 3).
Figure 3: Credit card delinquencies are still lower than the pre-pandemic period3
Inflation expectations add to the case for gentler rate hikes
Although inflation has yet to moderate, the good news for the Fed is that inflation expectations are moderating, indicating rising confidence in the job the central bank is doing. Markets are now projecting close to target CPI levels, and consumer expectations have moved sharply in the right direction (Figure 4).
Figure 4: Inflation expectations make an “inflation trap” less of a danger4
This will no doubt make policymakers more comfortable about avoiding a 1970s-like inflation expectations trap (a continuous feedback loop whereby people pull forward consumption thinking inflation will keep rising).
Further, recent declines in gas prices, improving semiconductor supply, and base effects will likely provide the Fed additional comfort.
In our view, this makes it less likely that the Fed will need to raise rates so aggressively that rate cuts will be needed by next year.
Investors should avoid getting ahead of themselves
In 2018 and 2019, the Fed pivoted abruptly, moving from hiking to cutting cycles over just seven months. The economic cycle has been playing even faster since the pandemic hit in 2020, with a sharp recession followed by equally sharp recovery.
However, as monetary policy finally returns to a semblance of historical “normalcy”, the speed of the cycle might finally be returning to something closer to normal too.
We believe the important thing for investors is to avoid getting ahead of themselves. Rates are still rising for now and quantitative tightening continues in the background. We believe volatility is still inevitable, particularly given geopolitical considerations.
However, given the significant repricing in credit markets, we believe corporate credit market pricing is delivering opportunities to selectively add credit exposure.