ACTV - That's It Hikes Are Done And Rates Have Peaked At 5%

2023-05-06 08:48:02 ET

Summary

• This week, the Fed Funds Rate was raised to 5-5.25%.
• Rates are now in restrictive territory and the Fed has changed their tone.
• A rate pause is the most likely outcome next month, in our opinion.
• A picture is worth a thousand words, but a chart is worth a thousand pictures.

The Federal Reserve raised the Fed Funds Rate by 25 basis points to a range of 5-5.25% on May 3rd. We believe this will conclude the rate hiking cycle and here are the reasons why:

• Fed Funds rate has exceeded the 2 Year Treasury rate
• Fed Funds rate has exceeded the core PCE rate
• Real rates are sufficiently restrictive
• Federal Reserve narratives have shifted dovishly
• Pressures from higher rates are mounting

Thus far, the futures market agrees with our assessment pricing in a 90%+ probability of no rate hike in June. The FOMC dot plot is leaning towards slightly higher rates between 5.125-5.625% by the end of the year. What comes in June will depend on the economic data between now and then. While 25 basis points is not off the table, we now believe for the first time this hiking cycle that rates are likely to have peaked and that the Fed is poised to pause rate hikes.

The Rate Level Is Effective

The primary reason that the Federal Reserve has been raising rates is to quell inflation. To do so, they must raise rates to a level that is restrictive enough on the economy. The first sign that we can examine to see if they are restrictive enough is the bond market. Specifically, the rate on the 2 Year Treasury is an indication of where the bond market expects restrictive territory to lie. During each of the previous three rate hiking cycles the Federal Reserve has paused hiking rates once the FFR was sufficiently above the 2-year rate. Today, the FFR is more than 1% above the 2-year.

It is important to measure the FFR against measures of inflation to determine real rates. Higher real rates are incrementally more restrictive. The Fed prefers to examine core PCE as a measure of inflation. Today, the FFR is above YoY core PCE by about 40 basis points.

Similarly, it is important to capture the momentum of inflation which requires looking at inflation data on a monthly basis in addition to year over year. The annualized monthly change in CPI has been falling and the real rate of the 2-year Treasury measured against this continuous measure of inflation is currently positive by 3.6% (blue line in graph below). This is in line with the median real rate experienced between 1992-2020. Each of the last three hiking cycles have paused with real rates in this range.

Fed officials are aware that changes in monetary policy experience " long and variable lags " when impacting economic conditions. It is widely understood these lags can take 12 months or longer to take full effect. Looking back over the previous 12 months, the FFR was at 0.33%. The changes in FFR in the chart below demonstrates the changes in monetary policy that have not yet been fully experienced by the economy.

Pressure Is Mounting

Increases in interest rates are now aggressively manifesting as issues that are putting pressure on policy makers. Firstly, the cost of servicing the government debt is growing rapidly. While the Fed is considered independent of the Federal Government, and their decisions uninfluenced by government considerations, we are skeptical that this view completely holds true. The increases in interest rates has caused the interest payments on Federal Government debt to swell by 54% over the past year. This has resulted in an increase of interest payments as a percentage of gross domestic product to 3.5%, the highest since 2000.

The relationship between the Fed and U.S. commercial banks is more apparent. The Fed has a duty to maintain financial stability, including these banks. Recently, that stability has become questionable with a series of bank failures starting with Silicon Valley and Signature Bank which followed to the collapse of First Republic Bank on May 1. The underlying cause of these collapses is a significant accumulation of unrealized losses on bank balance sheets. Normally, these unrealized losses would not be problematic if held to maturity. But due to extraordinary outflows of bank deposits, these banks are facing liquidity issues that lead to failure.

Bank deposits continue to decline as depositors withdraw funds to earn more attractive yields outside of their banking institution. The rise in Treasury rates and money market funds has exceeded the rise in bank savings rates because banks are largely invested in lower yielding loans and cannot afford to raise yields without erasing profit margins. The speed with which the Fed has raised rates has exacerbated this issue because banks have not had enough time to rollover their assets to higher yields.

In his opening remarks, Chairman Powell said during the May press conference that:

Conditions in [the banking] sector have broadly improved since early March, and the U.S banking system is sound and resilient.

Within hours after the press conference, several regional bank stocks began plummeting including WAL and FHN with PacWest Bancorp ( PACW ) falling as much as 50% before rebounding. This kind of behavior is not normal or a sign of system resilience.

Notably, this month's FOMC statement contained a change in narrative with major implications. This is what the previous statement said:

The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.

This is what the statement was replaced with:

In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.

This new statement opens the door to a policy change and that change is a pause. The evidence we examine supports this view. It does not, however, support the view that rate cuts are imminent. Finally, during Q&A Powell had this to say about recession:

...the case of avoiding a recession is, in my view, more likely than that of having a recession. But it's not -- it's not that the case of having a recession is -- I don't rule that out, either. It's possible that we will have what I hope would be a mild recession.

The fact that Powell and other committee members are discussing recession as a plausible outcome indicates that they are using more discretion when setting rate policy. The Federal Reserve is expected to have strong disincentives to raise rates into recession.

Conclusion

It is possible that strong economic data between now and June will push the Fed to decide on another 25 basis points of rate hikes. Even the Fed does not yet know. We do not expect that as our base case scenario now. For the first time during this hiking cycle we believe the Fed will announce a rate pause at the next FOMC meeting. While this may appear to be supportive of risk assets, and they are expected to exhibit strength in response if history is a guide, history also suggests that rate cuts follow rate pauses and cuts come in response to serious economic weakness. Traditionally, risk assets do not perform well in the wake of rate cuts.

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