The disconnect between the Fed’s own expectations of interest rates over the rest of the year, and those of the market, suggests two very different central banks. Which one emerges, over the rest of 2023, has considerable implications for investors.
The Fed is positioning itself as tough on inflation and reasonably confident that if any further financial crisis emerge that it has the mechanisms in place to deal with them.
Its interest rate expectations are shown in the latest ‘dot plot’ chart, released on March 23 (at the last policy meeting, when rates were raised by 25bp). The chart suggests a consensus amongst those at the FOMC policy meeting for one further 25bp rate hike this year, presumably at the next meeting on May 3, with no cuts in the autumn. This would take the target Fed Funds rate to a range of 5%-5.25%. *
There was a hint that, but for the bank crisis of last month, interest rate forecasts would be higher. Jay Powell, chair of the Fed, said that crisis has tightened monetary policy, by making credit scarcer and so is partly helping reduce inflation.
But the market begs to differ. It is currently pricing in no hike in May and two cuts at the end of the year. It sees inflation falling and worries that more leveraged investments/ sectors will break under the strain of high interest rates. It seems inconceivable that the Fed would want to risk this.
The Fed has not yet beaten inflation
But the Fed, along with the ECB, is acutely aware of the perils of being seen to ‘go easy’ on inflation and allowing stubborn core inflation to persist. It fears long-term inflation expectations rising and feeding into wage negotiations, fuelling inflation.
Last week’s labour market data showed unemployment at just 3.5%, a little above a multi-decade low, and March average hourly earnings up 0.3% over February (from +0.2% the month before). There is still plenty of fuel to drive prices in services, which now dominates core inflation.
Certainly, the February JOLT new jobs report and last week’s March non-farm payrolls, both showed a reduction in new job openings. But these should be regarded as evidence that Fed policy is having an effect on the labour market, not that it is wining the war on inflation and can, therefore, afford to ease policy, perhaps to avoid a further financial crisis.
But didn’t we have good inflation data recently?
Yes, the Fed’s preferred measure of inflation, the Personal Consumption Expenditures (PCE) index, showed an easing of headline and core inflation when the February data was released on 31st March. Headline. From 5.3% the previous month, to 5%, on a year-on-year-basis and core from 4.7% to 4.6%. Both headline and core also fell on a month-on-month basis.
This potentially bodes well for today (April 12), when March CPI inflation data is announced. Estimates from Bloomberg (as of April 8) are for headline inflation to come in at 5.1% year-on-year (to a two-year low). But core inflation is expected to be up, at 5.6%, illustrating the stubbornness of the problem. **
The lower headline number illustrates a fall, on a year-on-year basis, for energy and food prices. These are excluded from Core inflation.
But the oil price is up $10 since this time last month and with the labour market responding slowly to rate hikes, the Fed would arguably be rash to send a signal to the markets that it regards its war on inflation as done.
What does this means for investors?
If the Fed’s ‘dot plot’ chart proves accurate, it will demonstrate a willingness to risk macroeconomic stability and recession, in order to achieve price stability. Sure, short-dated bonds will weaken (and their yields rise) as another rate hike comes to pass.
Equities will weaken, as the risks to economic growth and corporate profits increase.
But yields at the longer end of the yield curve will fall, as inflation expectations are reduced, giving gains to investors. The current negative 0.59% spread between the 2yr and 10yr Treasury yield could easily widen back to the 1% of a month ago as the inversion of the yield curve persists.
Over time, as the labour market and core inflation respond to the Fed’s tough love, short end yields will fall too. The ‘dot plot’ chart suggests the FOMC expect interest rates of around 4% by end of 2024. By the autumn, investors might start planning for rate cuts next year and for a new economic cycle. This would favour cyclical stocks (such as consumer discretionary and industrial).
But any sign of weakening of resolve at the May 3 Fed policy meeting, before core inflation is evidently on a falling projection, will probably be met with a steepening yield curve. Investors will sense that the Fed is making a compromise, between inflation and macroeconomic stability. Short term interest rates may fall, but they will not fall back to the 2% target because core inflation will persist.
The result, as has been discussed in a previous market commentary, will be ‘higher for longer’ inflation and interest rates. This would favour real assets (such as commodities and infrastructure), and defensive equities such as utilities and consumer staples.
As always, we remind investors of the advantages of holding a balanced multi-asset portfolio, in which many of the above-mentioned assets are held as a matter of course. Financial history demonstrates that, over the long term, this approach offers a better level of return, per unit of risk (volatility), than concentrating on any one single asset class.
Given that we lack a crystal ball to see how the rest of 2023 will unfold, the diversified approach is probably the best approach for the short term, also.
Ready to find out more?
At Brite Advisors USA, we work with UK ex-pats all over the USA on their investment needs, both retirement and non-retirement. Our US-based advisory team seeks to provide an outstanding experience for all clients.
We facilitate UK pension transfers using UK Self-Invested Personal Pension Plans (“SIPP”) provided by UK-regulated pension trustees for clients who want to save for their retirement by taking advantage of potential stock market growth.
Contact us today to find out more.
- No Investment Advice: This financial commentary is for informational purposes only and is not intended to be, and should not be, construed as an offer to sell or a solicitation of an offer to buy any security or financial instrument or invest in any equity or investment strategy. It should not be used to form the basis of any investment decision.
- Investment Risks: There are risks associated with investing in securities and past performance is not indicative of future results. Always seek professional advice before investing.
- Not Legal/Tax Advice: This financial commentary is not intended to be, and should not be construed as, legal, regulatory, tax, or accounting advice. Always seek professional advice and consult with your legal counsel, tax and accounting advisors when contemplating any course of action.
*The Fed “dot plot” chart can be found at: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20230322.pdf
**This market commentary has been published before the March 2023 CPI Data was announced. Brite USA will publish another market commentary, which will provide an overview on the released March 2023 CPI data.