FOMC meeting reaction

What happened?

The Federal Reserve raised interest rates by 75 basis points, setting its target range to 3–3.25%. This was in line with the market consensus, but the “dot plot” of the future rate path was somewhat more aggressive than expected, suggesting the Fed will hike by at least another 100bps—and more likely 125bps—by year-end. Two-year US Treasury yields moved higher immediately after the announcement, while 10-year yields moved lower.

In the post-meeting press conference, Chair Jerome Powell's remarks were clear. He repeated over and over that the Fed is focused on achieving price stability. The central bank expects that this will require a sustained period of restrictive monetary policy, sub-trend economic growth, and higher unemployment.

What is the economic impact?

Our view is that a federal funds rate of 4% is about the highest that the economy would be able to withstand, and the Fed is clearly threatening to raise rates above that level. On our forecasts, inflation may be low enough for the Fed to pause the rate hiking cycle after the December meeting. However, if inflation does not come down as quickly as we expect and the Fed raises rates closer to 5%, it will be difficult to avoid a recession.

What is the fixed income impact?

Benchmark yields moved higher, with the 2-year and 10-year peaking during the day at 4.11% and 3.62%, respectively. After the market digested the higher and more front-loaded move via the dot plot, investors’ focus shifted to the below-trend growth expectation alongside the lack of confidence from Powell that a soft landing was achievable given the level of restrictive interest rates. As a result, 10-year yields fell to 3.5%, while the 2-year remained a bit more stubborn though still fell to 4.03%.

The back end of the yield curve also responded as the 10-year and 30-year Treasury anticipated economic growth headwinds and quickly declined. The yield curve continued its inversion trend alongside the expectation that the hawkish rhetoric similar to the recent Humphrey Hawkins testimony will be enough to slow growth and inflation. The 2-year/10-year curve inverted by 11bps during the day, ending at –53 bps, near the yearly low of –58 bps. We anticipate this trend to continue as Powell reiterates the Fed’s primary goal of price stability.

With continued below-trend growth alongside a higher probability of potential recession over the next 12 months, we continue to prefer the up-in-quality allocation. Agency MBS, our preferred allocation, finally found a sounder confirmation from Powell that MBS sales will not occur soon. Alongside our up-in-quality preference, we continue to like short-end investment grade corporate bonds to enhance higher-quality yield, while also moving from floating-rate senior loans to fixed-rate high yield given the aggressive fed funds projection as well as the cheaper valuation and stronger fundamentals of high yield versus loans.

What is the equity impact?

After the Fed rate decision and press conference, equity markets gyrated between gains and losses, but ultimately the S&P 500 finished 1.7% lower on the day and 2.5% lower than where it was right before the announcement. While the rate hike of 0.75% was expected, stocks were likely mostly reacting to the Fed’s slightly more hawkish projections for the funds rate.

Market reactions to Fed policy decisions have been quite volatile this year, and, over subsequent days, markets have often reversed their initial knee-jerk response. Still, today’s update from the Fed does not significantly alter our view. The Fed remains squarely focused on getting inflation down to more acceptable levels and believes this could require a fairly lengthy period of relatively high interest rates. This means corporate profit growth will continue to decelerate, and there is a material risk that profits will decline at some point in 2023.

Given this backdrop, we continue to recommend a defensive positioning within equities. At a sector level, we reiterate our most preferred views on consumer staples and healthcare—two sectors that are less correlated with economic activity. We also like the energy sector, which has a very attractive free cash flow yield of 12% and is returning the bulk of that cash flow to shareholders through dividends and buybacks. Within styles, we continue to prefer value stocks, which are much cheaper than growth stocks and should therefore offer better downside support.

Did geopolitical risk also contribute to market volatility?

Aside from the Fed, geopolitical uncertainty also weighed on investor sentiment today, with Russia taking steps that represent an escalation in the war against Ukraine. President Vladimir Putin announced a “partial mobilization” of 300,000 reservists on Thursday and renewed his warnings of a nuclear threat.

A cease-fire in Ukraine remains elusive, in our view, and the conflict continues to be a source of potential volatility for markets, as well as a drag on global growth. The conflict has focused the attention of governments and companies on safety and security, over pure considerations of price and efficiency.

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