The Fed hiked rates by 25 basis points, taking the federal funds rate to a 4.75–5% range, but signaled that it is close to pausing the hiking cycle. In the Fed’s statement, the reference to “ongoing increases” in rates likely being appropriate—which has been in the statement since the Fed started raising rates a year ago—was removed in favor of “some additional policy firming may be appropriate.”
Updated economic projections showed that a majority of Fed policymakers (10 out of 18) still expect a further 25bps hike by the end of the year, leaving estimates of the terminal rate at similar levels to the December estimate.
With the potential that the Fed’s rate-hiking cycle could be finished, or at least paused, by the May FOMC meeting, yields declined. Two-year US Treasury yields fell 20bps and 10-year yields dropped 16bps.
Stocks sold off late in the session after US Treasury Secretary Janet Yellen said in a Senate appearance that the government “is not considering insuring all uninsured bank deposits.” However, in testimony last week, she hinted that all banks will be considered systemically important, so that uninsured deposits would be covered if a relatively small bank fails in the days ahead.
Fed Chair Jerome Powell made similar comments in his press conference, suggesting that all deposits are safe, while also refusing to make an explicit, blanket statement. It appears that Yellen and Powell are prepared to use their emergency powers to cover uninsured deposits at failed banks but are unable or unwilling to flat out state that all depositors will be protected.
History tells us that durable turning points for markets tend to arrive once investors begin to anticipate interest rate cuts and a trough in economic activity and corporate earnings. But the Fed’s actions and analysis of the economy suggest these conditions are not yet fully in place.
Fed rate cuts are not imminent. Futures markets have been pricing in rate cuts for later this year, but the Fed’s economic projections do not show rates falling until 2024. At the post-meeting press conference, Powell said, “Rate cuts this year are not our baseline expectation.” Another important point to note from the SEP is that GDP growth is projected to be only 0.4% year-over-year in 4Q23. Combined with the strong data already released so far this year, this implies, at best, that the quarter-over-quarter growth rate will be zero over the remainder of 2023. Further, they expect the unemployment rate to be 4.5% at the end of 2023, up from February's 3.6%. Given the current very high level of job openings, to have unemployment rise this much implies a pessimistic view on the economic outlook.
The Fed acknowledged that lending conditions may tighten further…Although the Fed’s policy statement said the US banking system is "sound and resilient," it also noted that recent stress in the banking sector is "likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation.“ In his press conference, Powell also noted that credit conditions could help tighten policy sufficiently to bring down inflation.
…which will weigh on corporate earnings. Lending standards have been tightening since the second half of 2021. The Fed's latest Senior Loan Officer Opinion Survey showed that a net 43.7% of banks are tightening standards for small firms and 44.8% for large firms. Based on the Fed’s view, this survey, which is correlated with earnings growth, looks set to deteriorate further.
We do not think that the US banking system has a widespread solvency issue, although some banks may raise additional capital and confidence remains fragile. Against this backdrop, and given the risks to growth, we prefer high grade and investment grade bonds, which should be more resilient in the event of a recession. We are more cautious on corporate high yield credit given deteriorating fundamentals and the risk of spillover from banking sector stress.
We also advise investors to diversify beyond US equities and growth stocks given the deteriorating outlook for earnings, high valuations, and risks arising from interest rate hikes. By contrast, we expect positive performance from emerging market equities, including China and Asian semiconductor stocks, and select European themes, including German equities.
Main contributors - Mark Haefele, Vincent Heaney, Christopher Swann, Brian Rose, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Original report - No surprises from Fed, but Yellen comments hit stocks, 23 March 2023.
Also see: Fed hikes 25 basis points, 22 March, 2023.