Not much change at the Fed – so, what now?

The Federal Open Market Committee (FOMC) meeting was a relatively uneventful one. This might sound like a bit of a “non-story” but in the current environment of higher than average rates volatility, we do think there are few points worth highlighting. After the meeting there was some intraday volatility, with rates settling at somewhat lower levels but not too far away from pre-FOMC ones.

Firstly, the US Federal Reserve’s (Fed) base case macro scenario of inflation declining and rates following suit as the year progresses remains intact. This is important as there have been some market commentators arguing that the next move should be a hike and that rates are not restrictive at current levels. Fed Chair, Jerome Powell strongly pushed back against these views and characterised a scenario where the next move being a rate hike as “unlikely”. He also mentioned that rates are restrictive and reiterated his comments from a couple of weeks ago, that should inflation be more stubborn than expected, then rates can be kept at these elevated levels for longer. We have no doubt that the Fed would hike rates if they felt monetary policy is not restrictive and inflation starts increasing sustainably again, but at the moment that seems far from their base case, a view with which we concur.

Secondly, the fact that there is considerable uncertainty about the “last mile” also remains intact and, therefore, predicting the exact timing of the start of the cutting cycle is not an easy task. The Fed does not seem to have taken the negative surprises in inflation and the better growth data so far this year as evidence that there is a renewed pickup in inflation, while at the same time they have acknowledged that confidence needed to start cutting rates has not yet arrived. He also repeated that the housing component and the supply side healing remain important drivers of the disinflationary process and sounded confident that these developments will continue. He confirmed inflation expectations are well anchored, and stated that he didn’t see either the “stag” or the “flation” components of the stagflation discussion that bubbles up from time to time. In summary, not much change in the Fed’s base case scenario.

Thirdly, the Fed’s message about the upcoming presidential election on monetary policy remains that this will have no impact. This view has been expressed by more than one Fed member in the last few weeks, and we expect them to remind markets of this view more often as the election approaches. Of course, the election is important and the consequences of Trump or Biden getting elected might not be neutral to monetary policy in the future. But the impact is likely to be more on the macro side than mere politics. If the fiscal deficit widens, then this needs to be taken into account, as aggregated demand and inflationary pressures would increase, for example.

What does this mean for markets? With the FOMC meeting and the Treasury’s Quarterly Refunding Announcement (QRA) now out of the way, we believe rates volatility might decline in the coming weeks and US Treasuries, gilts, bunds and other G7 government bonds might trade sideways until we find a new catalyst. After an 80 basis points selloff in 10-year Treasuries, further outsized moves require a continuous dose of increasingly bad news. We also note that the revised US Treasuries Quantitative Tightening (QT) cap of $25 billion (down from $60 billion) per month lent some support to rates. Markets are pricing less rate cuts for 2024 than the Fed predicted some weeks ago in their dot plot and for once we think the Fed might converge to the market view when they update them in a couple of months. The impact of the terrible escalation in the middle east conflict on markets has also proven to be limited and although it is impossible to predict how it will play out or get solved, it does seem that the bar is quite high for these events to become a main global market driver. Fixed income assets should benefit from this reduced volatility in rates and with yields as high as they are, risk-adjusted returns with a medium-term view look very attractive indeed.