Fed Moves Closer to Ending Rate Hikes
In this article we review:
- Our perspective on the recent Fed meeting and path of future rate hikes
- A potential conclusion of the Fed’s current tightening cycle by midyear
- Market implications of the presently inverted Treasury bond yield curve
- What this could mean for investors in the year ahead
As expected, the Federal Reserve raised the federal funds rate by 0.25% to a target range of 4.50%–4.75% at its February meeting, reflecting its smallest rate increase since March of last year. Regarding this development and the overall interest rate environment, we believe the following points are pertinent for investors:
We see two more 0.25% rate hikes between now and midyear, thereby concluding the current tightening cycle. It would be our best assessment the Fed will increase the fed funds rate by one-quarter point at both its upcoming March and May meetings and then hold tight (pardon the pun) for the remainder of the year. Given the Fed’s initial error in judging inflation to be transitory at its outset, as well as how the Fed will likely interpret the unexpectedly strong January employment report, we believe they will be reticent to reduce rates potentially too early and risk a resurgence in consumer prices.
The disconnect between Fed public commentary and market expectations continues, although we believe this should not be a material issue for the markets. There continues to be wide disparity between ongoing commentary from Chair Powell and other Fed officials implying the fed funds rate will likely move to a lower bound of 5% in the months ahead and remain there for some time, versus current federal funds futures market expectations of two rate cuts in the second half of the year. While it would be our judgment that rate cuts in 2023 are unlikely, we also believe markets could still react favorably to a conclusion of rate hikes by midyear.
The yield curve is now substantially inverted, and this favors short-term bonds. The absolute level of yield differential between the 3-month and 10-year U.S. Treasury bonds has reached its widest inverted margin in more than four decades (1.05% as of February 7) and on a percentage of yield basis close to its widest ever (4.68% vs. 3.63%). Over the past 50 years, there have been six previous inverted 3-month to 10-year yield curves varying in length from four to 17 months, with an average of 10 months before resuming an upward slope. Therefore, we would be cautious on longer-term bonds and favor the short-term bonds given the current curve has been inverted since October.
Even without rate cuts later in the year, we still believe the conclusion of rate hikes by summer could prove to be a catalyst for the markets. We feel markets could be well positioned for upside if the Fed concludes raising rates by about midyear and core rates of inflation decline into the 4% range. We continue to expect a year-end lower bound on the fed funds rate of 5% and believe a realistic yield on the 10-year Treasury bond for this time frame to be about 4%. We also maintain our year-end target on the S&P 500® of 4,400.
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