As expected, the Federal Open Market Committee (FOMC) decided to hike its key interest rate, the federal funds rate, by 25 basis points (bps; 100 bps equal 1.00%), to a range of 5.00% to 5.25%. Despite the banking sector’s ongoing wobbles—most recently, First Republic Bank’s takeover by JP Morgan over the past weekend—the FOMC sees fighting inflation as its highest priority.
That said, a wait-and-see approach going forward is more likely. Income data will confirm if the economy’s slowing progresses into the services sector and leads to a mild recession in the second half of this year. The U.S. dollar has continued weakening over the quarter, and the yield curve remains deeply inverted between 2 years and 10 years, signaling further growth slowdown. We can already see it in earnings, which have been down the past three quarters in real terms. This should feed into weaker labor market data and, ultimately, weaker inflation numbers.
Core inflation, however, trades stubbornly above the headline Consumer Price Index, and the latest survey data show higher long-term inflation expectations that likely make the Federal Reserve (Fed) more careful. Inflation volatility in capital markets, though, has continued to decrease as real yields have moved up and the market has started to shift from inflation worries toward growth worries. Growth-sensitive stocks have outperformed value stocks, and long-end yields have dropped this year—all signs of increasing growth uncertainty. The short-term interest rate market is expecting three rate cuts in the second half of the year—and all the way down to 4.3% in January 2024.
Our base case is for the Fed to be on hold until the inflation and growth data have weakened enough to justify a less restrictive monetary policy. This might take a bit longer than the market expects. In our inflation framework, we measure level (how high inflation is), breadth (how many goods and services are increasing at the same time), and persistence (how sticky inflation is). While level and breadth have continued to drop, persistence has just plateaued.
More patience will be needed over the summer until the Fed has a clearer sense of macro trends. In this environment, we believe that actively managing investments will potentially add value as economic divergencies between the U.S. and the rest of the world create ample opportunities for alpha. We continue to like bond exposure, which benefits from falling growth and falling inflation; stay neutral on equities, avoiding banks and preferring defensive sectors; and underweight inflation-sensitive assets like commodities.
CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.
