Is the Fed rate-hike pause still likely?

2023 was to be a relatively well telegraphed year, as opposed to 2022 which took investors by surprise. The idea was simple: in 2022, central banks had raised a wall of interest rates to protect our economies from a wave of inflation not seen since the 1970s. These rate hikes were to cause a slowdown in economic growth during 2023 without plunging the world into a deep recession – the ‘soft landing’ scenario. Investors would then have remained cautious for some time, preferring bonds to take advantage of disinflation, before returning to equities, whose valuations would have become more attractive as the necessary drop in corporate earnings was priced in. 

 

Need to know The Federal Reserve was expected to pause its rate hiking cycle over the next few months, but inflation is looking stickier than expected Markets have revised their rate expectations rapidly, for short rates and long rates alike. Cuts for the second half of 2023 have been gradually priced out For the time being, equity markets are taking the news rather well. Technology stocks continue their rally, defying their relationship to real rates. But for how long?

 

Best laid plans

The market consensus was that this second step would take place towards the end of the year. The fact that the Fed signaled at its last meeting a willingness to pause was consistent with this narrative. However, the story of 2023 now looks quite different and that change in narrative can be attributed to a series of data releases showing sticky inflation alongside a particularly strong labor market and a surprisingly resilient growth backdrop (even in the US) – probably affecting central bankers’ view of the current situation. The door is now open to new hikes. Here is our read of the pivotal month of May.

 

Real rates rising everywhere

If a single phenomenon were to describe the month of May, it would be the rise in long-term real rates. Over the course of the month, long-term real rates rose significantly across the board. Whether that be in the US, where rates rose by 20 basis points, the Eurozone, with 16 basis points, or, even more impressively, the UK, with real rates soaring by 56 bps, the observation is unambiguous – see Figure 1.

Real rates have risen everywhere, once again unexpectedly costing bondholders just over 1%, while cash yielded around 40 basis points. Meanwhile equities fell, too: a throwback to 2022 and positive bond-equity correlation.

This rise in real rates came at a time when the Fed was communicating its plans for a pause in its rate hike cycle – a pause that most investors hastily mistook for the end. Since the announcement of this pause, real rates have done nothing but rise, and inflation started looking stickier than expected. As a case in point, the Fed's preferred inflation indicator, the Core PCE, came out at 4.7% versus 4.6% the previous month, and the headline indicator itself came out at 4.4% versus 4.2% the previous month. How will the Fed handle this unexpected setback?

 

Figure 1: Trends in real interest rates in the US, Eurozone and UK

Source : Bloomberg, LOIM

 

Monetary policy takes centre stage (again)

The Fed's communication and, more importantly, the market’s pricing have evolved rapidly. On 5 May (two days after the Fed meeting suggested a pause) markets were anticipating that by December 2023, the Fed would have cut rates four times (by a total of 100 basis points). Since then, this expectation has gradually been revised downwards. By the end of May, the market was no longer expecting to see a single rate cut by December 2023. Figure 2 shows how, even on an intraday basis, the rise in real yields mirrors this revision in Fed expectations.

Even more interestingly, prior to this month, markets assigned virtually no chance to a rate hike occurring in June or July. This probability was revised considerably upwards over the course of the month. After the publication of the PCE deflator, it reached 60% for July 2023 (see Figure 3) – a clear challenge to the pause narrative. Various Fed Presidents have recently sought to protect the central bank’s credibility and maintain some optionality by opening the door to a hike in June or July.

 

Figure 2: Intra-day evolution of US real rates and futures-implied Fed Fund rates expectations for December 2023 during May 2023.

Source : Bloomberg, LOIM

 

Figure 3. Probability of rate hikes as calculated from Fed fund futures

Source: Bloomberg, LOIM

 

A market little affected

While news of rate hikes caused quite a rotation in 2022, May 2023 saw a very different price action. Let’s rewind and review recent history in Figure 4. As 2022 progressed, real rates started having less and less of an impact on the equity rotation. Value equities continued to outperform growth equities as real rates rose, but this response gradually tailed off, leaving a large gap between the two indicators.

Today, the situation is even more striking. Not only is the gap there, but the rotation has reversed: real rate rises in May coincided with growth stocks outperforming value ones. The inversion of this relationship – the ’NVIDIAsation’ of the equity market – should prompt investors to question the sustainability of this situation.

For the time being, one thing is clear: inflation is more persistent than expected and the pause in the rate hiking cycle could actually come later than anticipated. The equity market is taking the news with a certain benign neglect, which calls for some cautiousness on a medium-term perspective – past the current tech frenzy.

 

Figure 4: US real 10-year yields and performance of the value to growth ratio

Source : Bloomberg, LOIM

 

Simply put, the Fed pause is likely to be delayed by one or two FOMC meetings until inflation data starts to come back down in line with the target.

 

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises and global monetary policy surprises designed to track the recent progression of macroeconomic factors driving the markets. 

Our nowcasting indicators currently show:

• Our growth indicator declined this week, mostly out of Fed surveys reaching lower levels and as the situation in China showed deteriorating signs. Growth worldwide remains low and deteriorating at the moment
• The inflation situation has been showing some variations recently: from low and declining, inflation pressures have become “low and stable” – the Fed’s pause makes a lot of sense from that perspective
• Our monetary policy indicator continues to point to a certain moderation from our central banks, consistent with their “pause” communication. As explained above, with the rather sticky inflation, cautiousness remains essential for the moment

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM's nowcasting indicators gather economic indicators in a point-in-time fashion to measure the probability of a given macroeconomic risk - growth, inflation and monetary policy surprises. The Nowcaster ranges from 0% (low growth, low inflation and dovish monetary policy) to 100% (high growth, high inflation and hawkish monetary policy).

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