The Fed’s pivot is in sight

Comments by Franck Dixmier , Global CIO Fixed Income, AllianzGI, ahead of the US Federal Reserve meeting on 3 May 2023.

After more than one year of interest rate rises, we believe the current US Federal Reserve hiking cycle is coming to an end. A 25-basis points rate rise at the next Federal Open Market Committee meeting may be accompanied by a pause in tightening that should prove to be a pivot.

KEY TAKEAWAYS

• We expect the US Federal Reserve to announce a 25 bp rate hike at the Federal Open Market Committee meeting on Wednesday, as well as a pause in its monetary policy tightening.
• We believe the pause should prove to be the Fed's pivot – even if not announced as such – with a terminal rate of 5.25%.
• Investors' recognition of the end of the monetary tightening cycle is bullish and should favour steepening strategies on the US yield curve.

The latest US economic data does not make the Federal Reserve's task any easier. Activity is decelerating substantially, as shown by the first quarter GDP growth figure, which was below expectations at an annual rate of +1.1% quarter-on-quarter.[1] But core inflation, as measured by household consumption excluding food and energy (the core personal consumption expenditures), surprised by continuing to rise. Core inflation rose to +4.9% in the first quarter on an annual basis, compared with +4.4% in the previous quarter[2] and an expected +4.7% rise. This level remains far from the central bank's price stability objective. The persistence of high inflation levels should reinforce the Fed's belief in the need to continue tightening monetary conditions.

After 475 basis points (bp) of hikes in this cycle starting in March 2022, we expect an additional 25 bp hike at the Federal Open Market Committee (FOMC) meeting on 3 May. Markets are anticipating this increase. But what comes next is less certain.

In its assessment of inflationary dynamics, the Fed will have to take account of the tightening of credit conditions following the difficulties of the US regional banks. The regional banking stress should result in a significant contraction of bank lending to the economy in the coming months. Therefore, we believe that the Fed may also announce a pause in rate hikes to give itself time to assess more closely the consequences of past hikes on demand, and especially the impact of the regional banking tensions on credit supply.

The main question for markets is whether this is a temporary pause – or the real pivot of US monetary policy. Given the macroeconomic trends mentioned above, we would opt for a real Fed pivot – not announced as such – with a terminal rate of 5.25%.

That investors are anticipating the end of the monetary tightening cycle is bullish and should encourage steepening strategies on the US yield curve.?

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[1] Source: US Bureau of Economic Analysis

[2] Source: US Bureau of Economic Analysis