SPUS - The Fed Likely To Cut In May June And July To 4.0%

2023-05-01 06:11:03 ET

Summary

• Economics 101 would suggest that the Fed may hike rates to the range of 5.0% to 5.25% because inflation is arguably still too high.
• But the Fed's thinking will not only be informed by inflation but also by politics, financial stability, and economic growth consideration.
• Reflecting on the recent stress in the banking system, the Fed cutting rates has become very likely, in my opinion.
• Markets, according to SOFR futures, are already pricing aggressive rate cuts, seeing rates approximately cut by half within 24 months.
• If the Fed cuts rates, history suggests that equity markets will rally, and I see the S&P 500 topping 4,300 by year-end.

All eyes are on the upcoming FOMC meeting, which is scheduled for 2-3 May. And while Economics 101 would suggest that the Fed may hike rates to the range of 5.0% to 5.25%, because inflation is arguably still too high, investors should consider that the Fed's thinking will not only be informed by inflation, but also by politics, financial stability and economic growth consideration.

Markets are not stupid: they are perfectly aware that inflation is not beaten for good; but they also understand that there is now a very high probability that the Fed will shift its focus towards overweighting financial stability considerations when making a decision on the third of May.

As of May 1st, markets broadly expect that the Fed will push through one last quarter-point increase, which is currently priced at a 80% probability according to futures markets, bringing the range to 5% to 5.25%. However, there is significant uncertainty as to whether Powell and his colleagues will indicate a pause after this. Now, while inflation continues to remain well above the target, markets price that the Fed may cut as early as June.

Personally, I believe the Fed may consider cutting by 25 basis points as early as May, adding another 25 basis point cut in June and again in July, bringing the Fed funds target range to 4.0% to 4.25%. I would like to point readers attention to the fact that markets, according to the Secured Overnight Financing Rate, are already pricing aggressive rate cuts, seeing the Fed funds rate cut in half within less than 24 months.

Accepting that there is considerable uncertainty related to where the Fed funds rate will be in the future (market prices reflect consensus, but the probability distribution could be very wide), I would like to highlight that, according to Piper Sandler's Benson Durham, the probability density distribution is strongly skewed towards lower rates by December 2023 expiry.

The reason why the Fed cutting rates has become so likely in the past 2 months is anchored on stress in the banking system, with the Silicon Valley Bank (SIVBQ) and Credit Suisse (CS) collapsing, the First Republic Bank (FRC) close to a bailout/ takeover and multiple regional banks in distress.

Specifically, readers are advised to pay attention to the fixed income securities portfolios held by U.S. banks. At the start of 2023, the unrealized losses linked to these banks', including Held-to-Maturity ((HMS)) and Available-for-Sale ((AFS)) securities, have skyrocketed to $650 billion.

With that frame of reference, it's worth noting that unrealized losses on held-to-maturity securities shouldn't carry much weight, in theory, because they 'merely' reflect mark-to-market losses. However, it's crucial to acknowledge that if the HMS and AFS portfolio of these banks had to be quickly liquidated for any reason, the fire-sale and loss-realization could pose a significant risk to financial stability. Moreover, investors should also be aware that mark-to-market losses on balance sheets has caused banks to stop trusting each other, to some extent, and the interbank funding market dried up.

Of course, the Federal Reserve is perfectly aware of these signs of financial distress, which is precisely why a "pivot" by the Fed now seems highly probable. As the saying goes, "the Fed will/must/should tighten until something breaks".

With that frame of reference, investors should consider that there is ample evidence that inflation has already started to come down significantly, and the upper bound of the Fed funds target rate has already topped the PCE inflation rate. Given the financial stress in the banking system, there is little justification for the Fed to stay so super hawkish.

In fact, the Fed has done an excellent job raising rates aggressively. And now officials, led by Jerome Powell, will play to avoid being blamed for the next 2008-like financial meltdown.

Equity Market Implications

So, I believe that the Fed will likely cut rates in May, in June and in July, to 4.0%. For the equity markets, this means a rally, if history serves as a reference: throughout the course of eight previous monetary-tightening cycles, the S&P 500 experienced an average increase of 13% in the year following the final interest-rate hike. Accordingly, I see the S&P 500 topping 4,300 by year-end, suggesting a reasonable x20 P/E multiple for FY2024 FWD.

Disagree with the thesis of this article? Here are two excellent hawkish-skewed reads from my colleague SA writers Damir Tokic and Michael J. Kramer

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