Investors are eagerly anticipating the upcoming May meeting of the Federal Open Market Committee (FOMC), responsible for setting interest rates and making monetary policy decisions. Recent speeches from Fed officials have dispelled any lingering uncertainty, leading to the widespread expectation of another rate hike.
As part of its year-long campaign to control inflation without triggering a recession, the FOMC is likely to raise rates by a quarter of a percentage point for the third consecutive quarter, while continuing to reduce its balance sheet by allowing assets to roll off. Since March 2022, the Fed has already raised rates nine times.
Despite the potential risks, the S&P 500 has managed to gain around 8% this year, reflecting investors’ cautious optimism that the Fed will successfully steer the economy towards a soft landing, bringing inflation back to normal without causing a recession.
Although the collapse of Silicon Valley Bank in March did not trigger a broader banking crisis, it has had an impact on the US credit market, which has tightened credit conditions and could potentially help the Fed in its fight against inflation.
Could This Be the Fed’s Final Rate Hike?
Currently, the bond market is indicating an 86% likelihood of the FOMC raising interest rates by another quarter of a percentage point—or 25 basis points—in its upcoming May meeting. This would bring the federal funds target rate to a range of 5.0% to 5.25%, in line with the FOMC’s prediction for the peak in interest rates, implying that the May hike could mark the end of the current cycle of rate increases.
According to CME Group, traders are betting heavily on the Fed raising rates in May, with only a 14% chance of no rate hike. Ironically, they also see a 65.8% chance of the Fed cutting rates to between 4.5% and 4.75% by the end of 2023.
Along with the rate hike, the Fed is expected to continue its policy of quantitative tightening, allowing up to $60 billion in Treasury securities and $35 billion in agency mortgage-backed securities to mature and roll off its balance sheet each month. While the Fed’s balance sheet has shrunk from its record high of $8.96 trillion in May 2022 to around $8.6 trillion, it is still more than twice its pre-pandemic size of $4.15 trillion in February 2020.
In March, the Fed revised its long-term economic projections, reflecting a potential slowdown in the economy. The Fed cut its GDP outlook for 2023 from +0.5% to +0.4%, and for 2024 from +1.6% to +1.2%. It also adjusted its forecast for the core Personal Consumption Expenditures Price Index, or “core PCE,” its preferred measure of U.S. inflation, predicting that it would rise by 3.6% in 2023 but only by 2.6% in 2024 as inflation eases.
U.S. Economy Holding Steady
The U.S. economy is flashing warning signs that it may be heading for a recession. Factors such as an inverted U.S. Treasury yield curve, a downturn in corporate earnings, and a cooling housing market have raised concerns. However, there is some hope for the economy as the latest employment numbers suggest that the labour market remains strong.
The U.S. Labor Department reported that the economy added 236,000 jobs in March, with the unemployment rate holding steady at 3.5%. The labour participation rate continued to rise, reaching 62.2%. Average U.S. wages were also up 4.2% from a year ago.
Despite these positive signs, there are concerns that a tight credit market could lead to a slowdown in small business expansion, which could increase the risk of a recession. Wall Street analysts are also predicting lacklustre growth numbers for the S&P 500 during the first quarter of the year, with projected earnings set to decline 6.5% compared to the previous year, marking the second consecutive quarter of negative earnings growth.
Inflation Finally Takes a Chill Pill
The good news is that the series of rate hikes appears to be having a tangible effect on inflation.
In April, the Commerce Department reported that the year-over-year increase in the Consumer Price Index (CPI) slowed to 5% in March, down from a 6% gain in February. Excluding volatile energy and food prices, the Core CPI increased 5.6% from the previous year.
However, according to Chris Zaccarelli, Chief Investment Officer at Independent Advisor Alliance, the latest inflation figures indicate that the Fed still has a ways to go. “Inflation remains too high,” Zaccarelli remarks. “The most recent Core CPI figure of 0.4% per month equates to nearly 5% annually, which is more than double the Fed’s target.”