Monetary Whiplash

Fed Hikes 25 bps 

The Fed raised its fed funds target rate an additional 25 bps during the March FOMC meeting. Fed funds rate is now 4.75-5.00%. Importantly, the Fed also provided comments that “the U.S. banking system is sound and resilient.” Much has been made about whether the Fed needs to pause or pivot its restrictive monetary policy due to banking instability. It appears the Fed remains resolute in its fight against inflation, which remains elevated, and it views financial conditions as stable. 

The Fed’s dot plot remains the same at 5.1%, which implies we are getting close to the end of this hiking regime. Chair Powell’s comments were interesting on future rate hikes as last presser he said, “ongoing rate increases will be appropriate” vs. today, “may be appropriate.” The Fed, of course, is watching the bank event and noted it will create tighter credit conditions and that may have an impact on future rate policy. This is obvious, but at least the Fed is paying attention and recognizes the environment – in contrast to the Fed’s delayed policy for the past two years. 

Treasury yields moved lower across the curve in reaction to the Chair Powell’s press conference. The futures market is telling us that the Fed will cut rates twice before the end of the year. Still, the Fed remains hawkish as they, “don’t see rate cuts at all this year.” The Fed is pricing in rate cuts in both 2024 (4.3% projected terminal rate) and 2025 (3.1% projected terminal rate).  

May 3 is the next FOMC meeting. 

Chart 1: Yield Curve Lower Since Year-End¹ 

Tug of War: Financials Tightening, Markets Easing 

As the Fed has consistently shared a “higher for longer” interest rate policy, markets have consistently priced in future rate cuts. The Fed is trying to micro-manage price instability and tight labor markets with rate policy. Fed policy manipulation created today’s price instability – staying too low for too long, and now raising at a historic pace. 

Financial conditions are clearly tightening. Recent bank failures let sunlight into some of the underlying instability amid highly concentrated, unregulated regional banks. More broadly, banks restricted financial conditions and we anticipate that will continue – supporting the Fed’s effort to slow economic growth. 

Financial Conditions Are Tightening 

Banks have been tightening their lending programs since the latter half of 2022. Banks tend to limit credit availability in expectation for deteriorating credit conditions. Economic growth slows when businesses cannot access loans and higher borrowing costs cause businesses to limit capex growth. 

Chart 2: Banks Reducing Loans From Balance Sheets, Increasing Loan Loss Reserves² 

Banks are allowing loans to mature and slowing the pace of issuing new loans, reducing the total loans outstanding. In tandem, banks are increasing their reserves to protect against credit losses. This dynamic should slow economic growth. 

Higher rates have had a significant impact on interest-sensitive sectors, like housing, for some time now. Higher interest rates have clearly had an effect on mortgage demand but has done very little to impact consumer demand more broadly. 

Chart 3: Higher Mortgage Rates Have Directly Impacted Mortgage Applications³ 

Market Pricing Creates Easing Conditions for Borrowing 

While banks restrict access to loans and maintain excess capital reserves, benchmark rates have fallen, yield curves have remained persistently inverted and consumer sentiment has stayed strong. Low unemployment, significant job opportunities, higher wages and elevated savings all support consumer confidence and resilient demand. An indication of consumer strength, existing home sales in February increased +14.5% m/m. Further, despite restrictive bank lending programs, real GDP increased +2.7% in Q4 and the Atlanta Fed’s GDPNow model predicts +3.2% in the current quarter. 

Overall, companies able to receive loans, particularly well-capitalized companies with strong credit ratings, are benefitting from the sharp drop in market rates, despite the Fed continuing to hike. As financial stability becomes a greater concern, we believe that we’re nearing the end of the Fed’s rate hike regime. The Fed still indicates a 5.1% terminal rate for this year, but market rates are moving lower and pricing cuts by year-end. 

Chart 4: Higher Fed Funds Rate Met With Resistant Treasury Yield⁴ 

Stephanie Link: CNBC TV Schedule 

Sources

1. FactSet (chart). As of March 22, 2023.
2. FactSet (chart). As of March 22, 2023.
3. FactSet (chart). As of March 22, 2023.
4. FactSet (chart). As of March 22, 2023.

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