FED decision: the market is still wrong
Federal Reserve Chairman Jerome Powell clearly indicated on Wednesday that the current cycle of rate hikes was nearing its end. However, he also confirmed that interest rates would remain elevated longer than investors had anticipated.
After a series of rapid rate hikes over the past 18 months, Powell stated that the Fed could now “proceed with caution,”. He reiterated at least a dozen times during a press conference that followed the central bank’s decision to leave rates unchanged.
In the quarterly economic report and projections released following a two-day policy meeting, 12 of 19 Fed officials stated that they still planned to raise rates again this year. What garnered the most attention from investors was the revelation that policymakers expect fewer rate cuts in 2024 than previously anticipated, partly due to a more robust labour market. The projections also showed that they expected more inflation than previously anticipated next year, and it would only return to their 2% target in 2026. In other words, the smooth landing of the U.S. economy, which seemed more distant three months ago, now appears within reach.
The U.S. economy has so far weathered the Fed’s historic tightening campaign, which raised the federal funds rate target range from near zero in March 2022 to 5.25% to 5.5% in July, the highest level in 22 years. Consumer spending remains strong, and the labour market is stable, although employment growth is beginning to slow. The new projections reflect this reality.
In June, the central bank projected two rate hikes in 2023, which has not changed. The Fed will increase these rates either in October-November or next December. However, in 2024, the Fed previously expected a cut of nearly 100 basis points in the latter part of the year. This is no longer the case. The central bank anticipates a 50 basis point cut at the end of 2024 (5.1%), meaning the spectre of a U.S. recession has faded.
During the press conference, Powell emphasised that policymakers were facing significant uncertainty. In other words, depending on data developments, the timing of a rate cut could be postponed. This is an interpretation that investors have not factored into their expectations. The market has only heard that it’s not necessarily about going higher but staying at higher rates for longer. Now, it’s not about the level but the duration.
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With a series of potential economic headwinds on the horizon, including rising energy prices and a strike by the United Auto Workers, investors remain sceptical about the possibility of the Fed carrying out another rate hike this year. Futures contracts show roughly equal odds of a new tightening in 2023. Future rate expectations also indicate that they expect a more challenging economic environment, and that the Fed could cut rates more quickly than it suggests. This has been their thinking throughout 2023, and they have been wrong.
Considering the ECB’s clear statement that the rate hike cycle is over and a much more deteriorated economic situation than in the United States, the Euro would continue declining against the dollar. If the resilience of the U.S. economy continues, this depreciation of the European currency could persist into the first half of 2024.
If the Fed’s forecasts are correct, the U.S. yield curve should normalise, meaning an increase in long-term U.S. rates. This could put more pressure on emerging market debt.