Fed Pauses But Keeps Hawkish Tone

As expected, the Federal Reserve held interest rates steady at their 5.25% to 5.50% range but indicated it still expects at least one more hike before the end of the year. ⏯️

Very little changed in the Fed’s statement since July. However,  its economic projects and “dot plot” both changed notably. 👀

In terms of economic projections, the Fed now expects 2.1% YoY growth in 2023 vs. its 1.00% projection in June. It also expects the unemployment rate to end the year at 3.8% vs. its June forecast of 4.1%. As for inflation, its PCE inflation projection ticked up by 10 bps to 3.3%, primarily due to higher energy prices. And its Core PCE inflation projection ticked down by 20 bps to 3.7%

What did not change was its Fed funds rate projection, which remained steady at 5.6%, implying one more hike in 2022. Looking beyond 2023, its 2024 and 2025 median projections for the federal funds rate were both revised upward by 50 bps. 🔺

This differs significantly from where the Fed fund futures market currently prices in rates. Before today’s meeting, the market’s implied probability of the Fed keeping rates steady through year-end was well over 50%, and the most likely outcome was for rate cuts to begin in June of 2024.

Clearly, the market’s and Federal Open Market Committee’s (FOMC) expectations are not aligned. And if the Fed maintains higher rates for longer than anticipated, that’s a negative for the stock market. Hence, we saw both the stock and bond markets sell off in tandem today. 📉

As for what’s changing the Fed’s outlook? The economy and labor market continue to hold up far better than anyone expected. The labor market has shown some signs of softening over the last year, with wage gains moderating and the ratio of job openings to available workers improving. However, tighter financial conditions are taking a longer-than-anticipated time to deliver the economic weakness the Fed is looking for. 🕰️

As a result, the only thing the Fed can do is to keep rates higher for longer until it achieves its desired effect. With inflation projected to remain well above the Fed’s 2% target for at least the next year, tighter financial conditions are here to stay. Barring an economic shock that brings inflation down faster, Powell is carefully avoiding giving the “doves” any reason to loosen those conditions. 

U.S. treasury yields ticked up on the news, with the 2-year hitting its highest level since 2006. We’ll have to wait and see if they continue rising in the days ahead. Institutional speculators are certainly betting on it, as the commitment of traders (COT) data shows historically large short positions against Treasury bonds across the yield curve. 😮

While most are paying attention to the Fed, it’s a busy week for central bank decisions. China’s central bank left rates unchanged today as it looks to stimulate its sputtering economy, and Brazil is expected to cut by 50 bps tonight. Meanwhile, Indonesia, the U.K., South Africa, and Japan will all release their rate decisions tomorrow. 📝

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