Hawks Fly at September Fed Meeting
In this article we review:
- What now looks to be a more hawkish profile coming from the Federal Reserve and a likely ”higher for longer” path of interest rates
- The diminishing probability that the Fed can achieve a soft landing of curtailing inflation while avoiding recession
- The currently inverted state of the Treasury bond yield curve and its history as a recession warning signal
- Why investors will probably need patience, tolerance for volatility, and a long-term focus in the coming months
Earlier in the year, we stated the Federal Reserve was in a transition from walking a tightrope to driving a fire engine. The Fed’s recent September meeting now looks to have been the official moment it tossed the tightrope and fully revved up the firetruck.
The Fed concluded its September meeting by raising the federal funds rate by 0.75% to a target range of 3%–3.25% while also projecting a more hawkish outlook for the months ahead. Following the previous week’s higher than expected consumer price index (CPI) data for August, we believe the Fed’s pace of rate hikes between now and year-end will remain aggressive and that investors should consider the following key points:
- We see the Fed’s message as one of a “higher for longer” course of interest rates. Along with its statement raising the federal funds target range, the Fed also released its quarterly Federal Open Market Committee Participant’s Assessment of Appropriate Monetary Policy, better known as the Fed’s dot-plot. In this anonymous survey of the Fed’s 19 members, median expectations have risen to a federal funds rate of approximately 4.4% by year-end 2022 and 4.6% by the end of 2023. This is up considerably from the June dot-plot of 3.4% and 3.8% for those time frames, officially refuting any distant hopes potentially remaining of a Fed pivot to lower rates in the year ahead.
- We are increasing our federal funds rate target to a lower bound of 4.5% for year-end 2022 and believe a realistic range on the 10-year Treasury yield to be 3.75%–4%, reflecting a fully inverted yield curve. These higher rates represent expectations of two more 0.75% rate increases at the November and December Fed meetings combined with the committee’s continuing monthly balance sheet reductions of $95 billion regarding current Treasury bond and mortgage-backed securities holdings. At the current time, we view a terminal federal funds rate to be reached in 1H 2023 in the 4.75%–5% range.
- The path to lower rates of inflation also appears to be elongated. With recent CPI data displaying headline year-over-year inflation of 8.3% and core inflation of 6.3%, it now appears the timeline on moderating the pace of inflation toward more manageable levels will likely extend into 2023. While we continue to expect core inflation to mitigate into the 4% range based on demand impacts of Fed rate hikes, softening of the labor markets, and some loosening of global supply chain bottlenecks, such progress now seems less likely to occur before year-end 2022. Until then, we expect the Fed to remain vigilant in its efforts to curb inflation even at the expense of a more widespread recession.
- We believe the probability of the Fed achieving a soft landing is now remote. The window is rapidly closing on the likelihood of the Fed meaningfully curtailing inflation while avoiding a recession over the upcoming year. We estimate the probability of a full-fledged recession lasting up to one year and resulting in rising levels of unemployment and peak-to-trough absolute gross domestic product (GDP) declines of 1% or higher to now be in the range of about 80%.
- Treasury bond yield curve now flashing stronger recession signals. The 2-year versus 10-year Treasury bond yield curve continues to further invert and, now at 0.51% (September 23), is reflecting its highest spread since 1982. The inversion of these two rates has historically proven to be a mostly accurate indicator of a pending recession. We expect an even more historically accurate predictive yield curve signal, that of the 3-month to 10-year yield spread, to cross over into inverted territory by year-end as the Fed continues to hike rates. This also appears consistent with recently declining expectations for 3Q 2022 GDP, as seen in the Atlanta Fed’s current tracking estimate (September 20) of only 0.3% annualized growth, down from 2.6% less than a month ago.
- Expect continued stock price volatility in the months ahead. We are maintaining our year-end price target on the S&P 500® of 4,050 but recognize weekly and daily volatility in the equity markets will remain high. Key developments for investors to look for in addition to interest rates and inflation include revisions to CY 2023 corporate earnings expectations, 3Q GDP growth results, corporate bond credit spreads, and the upcoming November midterm congressional elections.
As stocks potentially test the mid-June lows of this bear market cycle, we emphasize opportunities in the equity and credit markets rest with a potentially favorable set up during CY 2023 based on core inflation moderating into the 4% range and a pending recession being more moderate than prolonged and severe, combined with a corporate earnings recovery expected in 2024. Until then patience, tolerance for volatility, and a long-term focus may be required.
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The 2-year Treasury rate is the yield received for investing in a U.S. government-issued Treasury security that has a maturity of two years.
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