The Fed pause may be upon us, but so may be the impact of higher rates

• This past week, markets were faced with a triple whammy of data: A Federal Reserve interest-rate hike (perhaps the last of this cycle), ongoing turmoil in the banking system, and a key jobs report for the month of April.
• After raising interest rates by over 5.0% in a little over one year, the Fed may finally be considering a pause in its rate-hiking campaign. But the long and variable lags of the past year of interest-rate increases may already be upon us and impacting the real economy. This can be seen from the uncertainty in the regional-banking system and incremental tightening in lending standards, as well as softening in manufacturing and the housing sector.
• In our view, a mild recession in the U.S. remains likely, although still buffered by a labor market that has remained relatively resilient in the face of higher rates and higher labor costs. Overall, market volatility may increase after a nice rally to start the year (albeit driven by narrow equity sector leadership). We see opportunities forming, however, in both stocks and bonds, as the ongoing bear market yields to a potential bull market phase by year-end.

The Fed says no to rate cuts – markets don't buy it yet

On May 3 last week, the Federal Reserve implemented what perhaps could be the last interest-rate increase of this hiking cycle. The Fed raised rates by 0.25%, its 10th consecutive rate hike since March 2022, bringing the fed funds rate to 5.0% - 5.25%.?

In our view there were three key takeaways from this month's Federal Reserve meeting:

1. The Fed language indicated that a pause in rate hikes may be likely: While Chair Powell did not comment explicitly that the Federal Reserve was ready to pause interest rates, some of the language in the Fed statement hinted that a pause may be coming. The statement removed the phrase, "some additional policy firming may be appropriate," and replaced it with language that it would assess incoming data to determine "the extent to which" additional tightening would be appropriate. For many investors, this change was a signal that the Fed no longer assumed that further rate increases were appropriate. In our view, the Fed will likely now pause its rate-hiking campaign, particularly given some of the turmoil in the banking sector, to assess both the economy and inflationary trends.
2. Fed Chair Jerome Powell pushed back against the notion that the Fed may soon cut rates: While the Fed may be considering pausing its rate-hiking cycle, Powell pushed back on the notion that rate cuts may be coming soon as well. He noted that "it would not be appropriate to cut rates" given inflation remains elevated and may take time to ease back towards the 2.0% target. Nonetheless, markets continue to price in Fed rate cuts, as early as the September meeting. In our view, the strong labor report for April makes it incrementally less likely that the Fed will cut rates, and it will most likely take the approach of an extended pause. We see a credible case that the Fed could signal rate cuts by year-end if inflation is more meaningfully back towards 2.0%, or if the economy has materially weakened, neither of which is in place currently.
3. The Fed continues to see the banking system as healthy:?Despite the ongoing turmoil in the regional banking system, Fed Chair Powell reiterated the message that the U.S. banking system is "sound and resilient." He also noted that the "conditions in the banking sector have broadly improved since early March," which seemed somewhat dated given the recent turmoil we have seen in regional banks like PacWest Bancorp. Nonetheless, the Federal Reserve, as the lender of last resort, also has a role to play to instill confidence in markets that the banking system remains stable and healthy, which may in part be why Powell offered a more optimistic view on the banking crisis. In the end, crises of confidence take time to stabilize, and, in this case, we may also need to see further support from the government or regulators.

The turmoil in the banking sector rolls on – what are the implications?

Despite the Fed's more optimistic take on the banking sector, regional banks in the U.S. continue to come under pressure. After First Republic Bank was acquired by J.P. Morgan last weekend, this past week additional West Coast-based regional banks, including PacWest Bancorp, Western Alliance, and Zions Bank, all saw substantial declines in their share prices, before rebounding somewhat on Friday. PacWest, which is lower by over 70% year-to-date, had announced that it is seeking strategic alternatives, including a potential sale of its business, and will seek to maximize shareholder value1. This comes even as PacWest highlighted that it has not experienced out-of-the-ordinary deposit outflows and that its cash and liquidity position exceeds its uninsured deposits. Nonetheless, markets have been searching for "who is next" among regional banks, and we would expect further intervention and consolidation among the 4,100 commercial banks in the U.S. in the months ahead.

However, while these crises of confidence take time to stabilize, the Fed and government stand ready to support the banking system with liquidity if needed. And larger banks, including J.P. Morgan and Bank of America, have also stepped in to provide capital and advisory services to their regional peers.?

In our view, we see two broader implications of this recent banking turmoil:

1. Credit conditions will likely continue to tighten from here:?As deposit volatility continues, U.S. banks may tighten lending standards further, making it incrementally more difficult for consumers and corporations to get loans. Keep in mind that this credit tightening had already been happening, even prior to the March banking turmoil, and puts downward pressure on economic activity. In some ways, this credit tightening may do some of the work for the Federal Reserve as well, which has been looking to cool consumption through rate hikes.
2. Additional regulation on regional banks is likely:?The Federal Reserve has also indicated that it plans to re-examine how it regulates regional banks, perhaps adding more stringent regulations, higher capital requirements, and some form of stress testing for banks with over $100 billion in assets. While this enhanced oversight may take time to roll out, the direction of travel is clear – regional banks will have to maintain better risk-management practices and be subject to increased scrutiny.

Will the labor market be the last shoe to drop??

Despite higher rates and uncertainty in the banking system, the labor market has been a source of strength in the U.S. economy. This past week's jobs data was no exception, as U.S. nonfarm payroll jobs increased by 253,000 in April, above consensus estimates of 185,000. But there were meaningful downward revisions to both the February and March figures, bringing the three-month average jobs gain to just 222,000. The unemployment rate came in at a healthy 3.4%, still near multidecade lows. Wage growth in the U.S. also remains elevated, at 4.4% year-over-year, still above the Fed's target range of 3.5% for wage gains.?

However, historically the labor market tends to be a lagging indicator of the economy and thus could weaken later in the cycle, especially if bank tightening weighs on consumption and corporate hiring plans. We have already seen some early real-time signs of softening in the labor market, including weekly jobless claims figures that have trended higher and job opening rates that have moved lower. We would expect the unemployment rate to rise this cycle, but more moderately than in past downturns, likely remaining below 5.0%. This is also in line with the Fed's own expectations of a peak 4.6% unemployment rate this cycle.

Market rally remains fragile near-term, but opportunities forming for long-term investors

Overall, markets have moved higher this year, with the S&P 500 Index up over 7% and the technology-heavy Nasdaq up over 15%, but the rally thus far may be fragile. The equity leadership in the market is narrow, with quality growth and defensive sectors leading the way. Parts of the market that are more sensitive to economic growth seem to be lagging, including cyclical sectors like energy and financials, and small-cap stocks, which tend to underperform in a slowing economy. Treasury bond yields have also moved lower since their recent peaks in early March, perhaps as investors seek safe-haven assets and as growth concerns rise.?

After a nice start to the year, markets are now facing the impact of the Fed's rapid rate-hiking cycle: a tightening banking sector and a potentially slowing economy. We would expect market volatility to continue in the weeks ahead, especially if the economy heads into an economic downturn or the banking system requires more intervention. However, we believe that last year's 25% fall in the S&P 500 captured some of the mild recession that may lie ahead.?

It is important to remember that the market cycle and economic cycle are distinct, as markets tend to be forward-looking. Thus, as the economy heads towards its bottom, financial markets may start looking to a period of recovery ahead. After an extended bear-market period over the past 16 months, we believe opportunities could form in the both the equity and bond markets as the economy recovers, especially given that, historically, these periods can offer outsized returns in the years ahead.