Stew’s Views: April 25, 2022
April 25, 2022
May the Fourth Be with You!
The Federal Reserve meets next Wednesday, May 4, in what will most likely be the second consecutive meeting during which they decide to raise rates. After slashing rates to 0% at the onset of the pandemic, the central bank has now begun the process of normalizing monetary policy.
What to Expect from the Fed for the Rest of the Year
The Fed has telegraphed its intentions quite explicitly, and the market has now priced in a 50bps rise at the coming meeting, after a quarter of a percentage point hike at the last meeting in March. In fact, the market has now priced in two consecutive 50 basis point rate hikes – at the May meeting and again at the meeting in mid-June, with mixed probabilities of 25 basis points and 50 basis points for the meetings in the balance of the year.
With six Fed meetings left this year, the market has priced the overnight rate to reach 2.75% by the last meeting, from its current target of upper band of .5%. At the time of this writing, the terminal overnight rate priced in the market is 3.25% by the third quarter of 2023.
At the last Fed meeting, the central bank released their summary of economic projections and the so-called “dot plot,” which is their estimates on the trajectory of the fed funds rate. As shown below, the Fed median dot is currently at 2.75% for the end of both 2023 and 2024. The market has become much more optimistic on the Federal Reserve’s ability to raise rates in their fight against inflation, as market pricing is well above Fed expectations.
A Safe Versus a Soft Landing
Interestingly, and in agreement with our view (seen on the purple line above), the market has also priced in Federal Reserve EASING (rate cutting) starting in the latter part of 2023. Soft landings of the economy are rare, as raising rates and reducing the size of the central bank’s balance sheet risk a meaningful slowdown in the economy.
Signs from the housing market, consumer and business confidence, and the freight market are signaling that a slowing economy is at hand. The oft-mentioned Fed rate hike cycle in 1994 created an economic soft landing, but in the episode the Fed was trying to reduce inflation that never went above 3%– it’s currently at 8.5%! A soft landing this time is certainly possible, but a “safe” landing is probably more accurate—a lot of bumps along the way, but hopefully no catastrophes.
It should be noted that given the increasingly indebted nature of the US economy, the Federal Reserve has not been able to raise rates higher than the immediate prior peak in the rate hike cycle since 1980 (see below). Each rate rising episode is a bit shallower than the last. Given the last rate hike cycle in 2015-2018 peaked at 2.5%, perhaps we should pencil in an overnight cycle peak this time of 2.25/2.5% instead of the market’s pricing of 3.25%.
Keep buying those front-end securities and portfolios!