Arguably, the most important factor for the stock and bond markets is the outlook for U.S. monetary policy. With the Fed at, or close to, the end of this cycle’s rate hikes, the debate will now turn to the timing for potential rate cuts. The debate will center on two schools of thought: 1) rates will be higher for longer (the Fed’s current stance), and 2) the Federal Open Market Committee (FOMC) will be forced into cutting rates sooner, and by a larger magnitude, due to economic concerns.
Source: Board of Governors of the Fed, as of 5/30/23. Shaded areas indicate U.S. recessions.
From the Fed’s perspective, Chairman Powell seems to be weighing the full impact of the 500 basis points (bps) in rate hikes that have already occurred in conjunction with the expected further tightening in credit conditions from the regional banking fallout. This puts the policy makers in full “data dependent” mode and has recently given rise to the notion that decisions will be made on a meeting-by-meeting basis.
Source: Bloomberg, as of 5/30/23.
However, the uncertainty quotient has been on the rise of late in terms of market expectations. Immediately following the May FOMC meeting, Fed Funds Futures were pointing to rate cuts beginning this summer, with the implied probability for the January 2024 level falling to as low as 3.93%, or not too far removed from the reading that was being printed at the height of the regional banking crisis in early March. Since then, the implied probability has increased in a noticeable fashion, rising almost a full 100 bps by Memorial Day.
Summary: While the Fed will be paying close attention to incoming inflation data, it is the labor market reports that could ultimately decide the central bank’s future course of action. Presently, the “higher for longer” interest rate camp seems to be in the majority at the FOMC, but rate cuts could come into focus in Q4.
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