The Federal Open Market Committee just decided to increase the federal funds target rate by 0.25%, resulting in a new target of 5.25% to 5.50%.
This increase shouldn’t come as a surprise. The Federal Reserve (Fed) laid its groundwork for this increase six weeks ago. After 10 consecutive rate increases, the Fed held rates steady in June, but the pause in hikes was accompanied by hawkish rhetoric.
While evidence of an economic slowdown should be expected after 10 consecutive rate hikes, economic data was surprisingly robust over the past six weeks. Jobs growth moderated in June, but net nonfarm payrolls still rose by 209,000 and the unemployment rate ticked down to 3.6%. It appears to us that the economy is at or near full employment. While year-over-year wage growth is softening overall, it’s still positive and elevated, landing at 4.4% in June. Sentiment measures indicate that consumers are worried about the future, and real retail sales numbers indicate they appear to be more thoughtful about their purchases, but consumers are still doing what they do best—consume! In many cases, they’re using their savings or credit cards to do it.
The latest data from the Institute for Supply Management® (ISM®) shows continued declines in manufacturing, which appears to have been in a recession for the better part of a year. However, even at ISM, there’s still some positive news: The ISM® Services Purchasing Managers’ Index posted a surprisingly strong month-over-month increase in June, bucking the recent downward trend in activity as the services sector keeps the U.S. economy afloat.
Given this decent economic data that’s coupled with lower but persistently higher-than-target inflation, it’s not surprising to us that the Fed took its finger off the pause button and gave us the 11th rate increase. The Fed’s language remains decidedly hawkish. This stance provides the Fed with good flexibility going forward. If inflation stays stubbornly high, the Fed has the flexibility to hike again. Should growth and inflation data roll over more meaningfully, the market will always welcome a pivot to more dovish language. The futures markets aren’t currently pricing in any additional rate hikes and hold that the Fed will start decreasing rates in the first quarter of 2024—just in time for the recession that many are forecasting.
Going forward, our base case is for the Fed to stay on hold until the inflation and growth data have weakened enough to justify less restrictive monetary policy. Much progress has been made, and our indicators regarding inflation breadth and stickiness continue to trend weaker for now. That said, we wouldn’t be too surprised to see another rate hike if economic data (especially from the labor market) still remain strong. We expect the weakening needed will take more time—patience from investors will be required. The bond and equity markets appear to be looking at the world through slightly different glasses: The bond market seems to expect a more meaningful slowing of the economy while the equity market seems more optimistic.
From a cross-asset-class perspective, little has changed: We continue to favor nominal assets like equities and bonds while avoiding inflation-sensitive assets like commodities. If growth doesn’t slow more meaningfully and default rates stay well behaved, we also see value in earning the income in higher-yielding bonds, like corporate or high yield bonds.
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