SUMMARY
We see a high probability of recession as 2023 continues, with inflation likely to trend lower. With the Fed likely then to pause its rate hikes and consider cuts, here is how we’re positioning bond portfolios.
- At their May meeting, in a unanimous vote the Federal Open Market Committee (FOMC) raised the Fed Funds Target Rate range by 25 bps to 5.00-5.25%, as expected by the market. This brings the target rate – and perhaps the terminal rate of the cycle – to right on top of the median dot plot expectation from the March meeting (5.125%).
- As they did last month, the FOMC statement noted banking system stress, although it actually brought forward “tighter credit conditions” to being a current situation as opposed to a prospective one: “The U.S. banking system is sound and resilient. Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain. The Committee remains highly attentive to inflation risks.”
- This is possibly a “dovish pause”, but the FOMC statement and Chairman Powell’s subsequent press conference were ambiguous. The Federal Reserve omitted language from the previous FOMC statement that “some additional policy firming may be appropriate”. Instead, going forward the FOMC “will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.” This shift in language provides the Fed with more optionality to perhaps adopt more of a balance-of-risks approach to further rate hikes, but it didn’t take them off the table.
- This marks the highest Fed Funds rate since August 2007, which at the time was the peak rate of the cycle before the Fed proceeded to cut rates down to near-zero (Figure 1).
- For now, the markets have priced out any further rate hikes for the year, though Powell specifically noted in his press conference that “a decision on a pause was not made today”, but that the Fed is close to and “possibly at” a sufficiently restrictive rate level.
- The Federal Reserve’s “quantitative tightening” program continues balance sheet reduction every month, primarily through Treasuries. The Fed’s holdings of securities outright have declined since the summer of 2022 by almost $650bn from $8.48T to $7.85T as of April 27th. But following the start of the U.S regional banking crisis in mid-March, an additional $328bn of the Fed’s balance sheet is being used as banks sought liquidity by pledging securities for cash loans through various Fed lending programs such as the Discount Window, the new Bank Term Funding Program, and loans to depository institutions established by the FDIC. (We do not view these programs as providing new, durable liquidity, but rather as temporary loans and are generally secured by collateral from the borrower).
- The bond market rallied slightly on the initial announcement as more rate cuts were priced into the curve, with year-end Fed Funds now priced at around 4.40%. The Treasury yield curve remains deeply inverted, but the degree of inversion has moderated over the past few months. 2-year Treasury yields at 3.93% are now only about 54bps higher than 10-year Treasury yields, down from over 110bps just two months ago right before the banking crisis. While an inverted yield curve typically precedes a recession with some lag (6-18 months), the subsequent re-steepening of that inverted curve has often signaled that recession risk has risen in the near-term. Equity market reaction was very muted initially.
