The Fed and the Markets

In a widely anticipated move the US Fed hiked the repo rate by 25 bps, thereby taking the federal funds rate target range to 5% to 5.25%. The second expectation of the market has also come through. The Fed has given soft indications that it may pause, or this might be the last one in the current rate hike cycle. While the job market remains resilient, as indicated by the low unemployment rate, the modest gains in economic activity and the stress in the banking sector have led to tighter credit conditions. The tighter credit conditions coupled with the expectations of a recessionary environment going ahead are the key factors that may influence a pause in rate hikes.

On the banking crisis, the Fed statement continues to maintain its view that, “The US banking system is sound and resilient.” The Fed statement has some key modifications on the interest trajectory front. The previous FOMC statement mentioned that “The Committee anticipates that some additional policy firming may be appropriate”, the same has been modified to “In determining the extent to which additional policy firming may be appropriate” in the current announcement. Further, the sentences such as “in order to attain a stance of monetary policy that is sufficiently restrictive” and “In determining the extent of future increases in the target range” are no longer part of the FOMC statement. The previous policy announcement clearly indicated future rate hikes; the approach of the current policy announcement is not so deterministic.

The FOMC members’ and street expectations align fairly well when it comes to the near term peak policy rates, whereas the divergence continues in terms of the timeline when the policy rates may be eased. The street expectations are still anchored towards a year end rate cut whereas the dot plot, released along with the March policy statement, indicates the FOMC members seeing a rate cut only in 2024.
At the current juncture, our views align with the street expectations that the policy rates have peaked for the current cycle. The key reason for this view is that the rates have been hiked at a very swift pace and from a very low level. The sudden rise of interest rates from a zero interest rate policy coupled with falling liquidity may create large disruptions in economic growth. While the FOMC may like to maintain that the banking system is sound, since the last policy one more mid-sized bank has shut shop.

The expectation of a pause may lead to equity markets heaving a sigh of relief, but we believe that would be temporary. As with the future policy decisions, the market direction too would be dependent on the incoming macroeconomic data with regards to the stress induced into the system by the sharp rate hikes over the last one year. The debt market may witness some easing in yields, given the expected economic stress and the Fed’s response to it.

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