May 08, 2023
Investment Strategy Brief: Potential Fed Pause, but no Pivot
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Below is a transcript of this week’s video.
Last Wednesday, the Federal Open Market Committee (FOMC) announced it would raise the fed funds rate by a quarter percent, an outcome that’s consistent with market-based expectations. The additional rate hike was decided upon unanimously by the FOMC members despite concerns of financial stability due to recent bank failures.
Although there are some signs of slowing economic growth and a weakening consumer, the robustness of the labor market continues to be a headwind for the Fed in achieving its price stability mandate. The FOMC statement removed language pointing to a likelihood of additional policy tightening, replacing it with language that hinted that any additional policy tightening will be data dependent, with many expecting a pause to future rate hikes. Market-implied expectations for June’s meeting has keeping a rate current with a small percent expecting a 25 basis point cut.
Given all of this, it’s helpful to take a step back and see the bigger picture. The result of more than a year of aggressive rate hikes has led to considerably tight monetary policy. In the past, when the fed funds rate was excessively over the neutral rate, that has often started the clock for an economic recession in the U.S. Fed pauses following excessive tightening preceded recessions which tended to show up 10-18 months after that point. Why the lag? It often takes time for monetary policy to permeate into the economy, often in the form of higher borrowing rates and reduced demand.
As tighter financial conditions continue to seep into the economy in the form of higher interest cost burdens, investors should monitor the ability of consumers, businesses and the government to service their debts. What determines how quickly those costs may rise? A significant factor is how soon they must return to the debt markets to borrow again. For instance, the federal government’s interest costs as a percentage of its revenues have ticked up much higher. With the federal budget operating at a deep deficit, new spending must be financed with new debt and existing debt must be rolled over as it comes due. As a result, higher rates are coming through into higher interest cost burdens. Businesses overall tend to operate with existing debt, too, but the average business is a profitable one. Rather than being forced to roll over existing debt, some could choose to retire at least some of that debt with profits to avoid the impact of higher rates. That’s perhaps a big reason why interest cost burdens have remained so low there for now.
Consumers are a bit of a unique case. Mortgages make up most of the household borrowing, for which they typically have a good degree of optionality for when and how they take on new debt. New prospective homebuyers could avoid higher interest rates by choosing to rent, and existing homeowners can avoid them by remaining in their current home. It’s therefore not surprising to see consumer interest costs as a share of disposable income not change much.
But issues with certain banks continue. U.S. regulators seized control of First Republic Bank which was then sold to JPMorgan. Considering the recent failures of Silicon Valley and Signature Banks, these three bank failures constitute a combined $532 billion in total asset value. Last banking failure of relatively similar size in 2008 was a bit different in some respects, as that amount was spread out over a couple dozen more bank failures, highlighting how this recent turn of events is both large and narrow at the same time.
One of the follow-through effects from all of this banking crisis is a continued tightening in lending standards as banks avoid taking unnecessary risk in the near-term. The Fed’s Senior Loan Officer Survey has picked up across various types of loans. That includes commercial real estate, industrial loans and credit card lines.
So given this, what is the state of monetary policy? Well to start, the fed funds rate remains meaningfully above the neutral level, suggesting that the state of policy is tight and will remain tight. However, there appear to be disagreements as to the finer points of where monetary policy heads from here. Several Fed officials continue to echo the intentions expressed in the FOMC’s December rate projections, which called for peak fed funds just over 5% and maintaining that rate through year-end. On the other hand, the fed funds futures market suggests that investors are betting against such a path. Instead, they are pricing cuts a few times in the back half of 2023. This discrepancy will have investors on the edge of their seats as we head into the second half of 2023.
- The Federal Reserve hiked rates 0.25% this month, with most expecting a data-dependent pause for now.
- Past periods of excessively tight monetary policy have not been favorable to the economy, often preceding recessions with a lag.
- Higher rates lead to higher borrowing costs and eventually impact the budgets of the consumer, businesses and the government.
- Recent bank failures are causing a tightening in lending standards, which may be a catalyst for recession in the U.S.
- The Fed is expected to keep rates well above neutral for the remainder of the year; the Fed is really holding rates high in order to bring inflation down further, but markets expect some cuts in the second half of 2023.
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