The Fed’s dot plot signals a higher terminal rate
Inflation continues to move in the right direction
Extended pause will drive growth and inflation lower
It’s hard to believe that the iconic movie musical, Grease, celebrates its 45th anniversary today. The movie enjoyed tremendous financial success, earning the top spot as the highest-grossing film when it was released in 1978 and was one of the best-selling soundtracks of all time. But I can still remember the dance moves and song lyrics like it was yesterday. The same way I’ll remember how the Federal Reserve (Fed) navigated one of the most tumultuous times in modern history, steering the post-pandemic economy through soaring inflation, labour shortages and an unprecedented amount of fiscal stimulus. The surprising resilience of the economy despite the aggressive tightening remains the Fed’s biggest challenge at this point in the cycle. Below we discuss how the Fed’s thinking will likely evolve for the remainder of the year and what it means for the markets.
Fed remains ‘hopelessly devoted’ to fighting inflation | This cycle has brought surprises, not just in the speed of the tightening, but also in the terms used to describe economic growth and the Fed’s policy stance. The new one is ‘a skip and a hawkish pause.’ But what does that mean? Well, after ten consecutive interest rate increases over the last 15 months, the Fed left the fed funds rate unchanged at 5.0% to 5.25% (e.g., they skipped) but signalled that interest rates may still be headed higher in the future (e.g., this pause is not necessarily the end of the cycle). The Fed’s updated projections pushed the median fed funds dot up 50 bps to an implied terminal rate of 5.6% (in 2023), lifted growth estimates (from 0.4% to 1.0%), and core PCE inflation (from 3.6% to 3.9%), and lowered the unemployment rate forecast (from 4.5% to 4.1%) by year end. Fed Chair Jerome Powell added there was strong support for more rate hikes given that inflation remains too high for the Fed’s comfort. While Powell indicated that the July meeting is ‘live’ and the dot plot implies the Fed is leaning toward two additional rate hikes, we suspect that the case for further rate hikes will weaken as the full impact of monetary tightening lies ahead and policy will become more restrictive as inflation recedes.
Inflation has ‘got chills and they’re multiplying’ | Favourable base effects and energy price declines pushed the headline inflation rate down to 4.0% on an annual basis – its lowest level in over two years. Furthermore, headline inflation on a three-month annualised basis has seen a more pronounced decline – falling from over 10% last June to just 2.2% today. While there are concerns that ‘core’ inflation is decelerating at a slower 5.3% year-over-year pace, due to stubbornly elevated shelter prices, more timely rental data from Zillow and Redfin suggest it is only a matter of time before the biggest contributor to inflation starts to rollover. Given the lag time before lower shelter costs feed through to the official statistics, the Fed has been following the ‘super core’ measure – core services excluding housing—which decelerated to 4.6% – its slowest pace since March 2022. While still elevated, it is trending in the right direction. And, as the dis-inflationary trend continues, it will be a welcome sign for Fed policymakers and a positive signal for both stocks (i.e., higher multiples) and bonds (i.e., lower yields).
The equity market keeps on ‘rockin’ and a rollin’ | Market sentiment has improved over the last few weeks. In fact, the American Association of Individual Investors (AAII) survey shows that bullish sentiment rose to ~45% – its highest level since November 2021 and the number of bulls minus bears has turned positive for the first time in over three months. Market breadth has improved significantly as the stock market rally is broadening, with over 55% of stocks in the S&P 500 trading above their 50- and 200-day moving averages. And with the earnings outlook improving in the second half of 2023 and the economy defying recession expectations, it’s no wonder the NASDAQ and S&P 500 have officially entered a new bull market. While history is on the market’s side – the S&P 500 historically rallies over 40% in the first year of a bull market and is up ~14% one year after the Fed ends its tightening cycle – the surge in bullish sentiment and ‘overbought’ conditions suggest caution may be warranted in the near term.
Higher long-term rates are not ‘here to stay’ | The Fed’s ‘higher for longer’ mantra has dominated news outlets since the Fed kicked off its tightening cycle last year. And yet, after 500 basis points of tightening, the Fed is still signalling that the fed funds rate is likely to remain high for at least the next few quarters. We warned this could happen as the Fed might want to preserve flexibility for future rate hikes if the economic data does not slow enough to cool inflation, but also to ensure that financial conditions remain appropriately tight. However, the longer the Fed maintains a restrictive policy stance, the more likely it is that growth and inflation will slow and the more challenging it will become for businesses to access the capital they need to grow and to service their debt. While shorter maturity yields will remain sensitive to a potentially higher peak in the fed funds rate (not our base case) or an extended pause (more likely), longer-maturity yields are more likely to react to slowing growth and inflation dynamics. The main risk to our 3.0% 10-year Treasury yield forecast is if the mild recession we are expecting in 4Q gets pushed out to 2024.
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