Will the Fed's Policy Bundle Morph into a Bungle?

Although the Federal Reserve’s decision to hold monetary policy steady was expected, its arrival carried a set of nuanced ramifications. Indeed, the Fed’s combined use of policy tools may fuel one of the very risks it is trying to prevent. Yet, a slowing pace of rate hikes may continue to support credit spreads as long-term Treasury yields drift higher.

The Fed met our expectation for a “hawkish skip,” on Wednesday, but with 50 bps of additional policy tightening in 2023 signaled in the Summary of Economic Projections (SEP), the Committee placed more emphasis on the “hawkish” modifier than we anticipated. Ex post, we can interpret the Fed’s decision as an attempt to achieve multiple objectives with multiple instruments.

The decision to “skip” a rate hike in June was likely motivated by risk management considerations, namely the desire to buy time to better assess the risk of non-linear damage to the real economy from banking sector stress and tighter credit. Pairing the skip with a hawkish SEP was likely meant to correct any misimpression that today’s decision was a definitive pause. In the Fed’s base case—and absent the metastasizing of banking sector woes—it is telling us that policy is not yet sufficiently restrictive to bring inflation back to target.

The danger of this policy bundle, of course, is that it becomes a bungle. That is, raising the terminal rate deeper into restrictive territory precipitates the risk scenario ("something breaks") that it’s trying to prevent. Put differently, it had a less risky option—instead of raising the expected peak in Fed Funds by 50 bps and reducing the expected end-2024 policy rate by 100 bps, it could have opted for signaling only 25 bps of further hikes this year, but less easing next year.

Looking ahead, with 12 of the 18 FOMC participants submitting an expectation for at least 50 bps of further hikes this year, we continue to anticipate a 25 bp hike in July. However, by September, we anticipate that a moderation of inflation pressures will keep the Fed on the sidelines for the balance of the year.

Hawkish (Hold) Surprise to Keep Upward Pressure on Long Rates

The markets took the 50 bps increase in the year-end 2023 “dot” as a hawkish surprise as yields at the front end of the curve moved higher.  Increased confidence in the Fed’s ability to contain inflation, however, could be seen in the decline in yields at the back end of the curve.  Between the rise in short term yields and the decline in long term yields, the 2/30-year curve inverted by an additional 10 bps to negative 83 bps (Figure 1).

Looking ahead, despite today’s resilience in the back end of the curve, the combination of a 5%+ Fed funds rate and the Fed’s hawkish bias relative to sub-4% yields on longer maturity Treasuries is likely to dampen interest in the back end of the curve and keep some upward pressure on Treasury yields.

Figure 1: The Fingerprint of a Hawkish Surprise: The Yield Curve Breaks with Short Rates Up, Long Rates Down (%; spread in bps)

Source: PGIM Fixed Income and Bloomberg.

Less Speed + Less Anxiety = More Buoyant Markets?

Risk markets were mixed with stocks falling on the announcement / SEP release before fully recovering during the press conference, while credit spreads widened slightly.  From a bigger picture perspective, however, the overall trend in credit spreads has been one of firming since mid-2022 as the Fed’s speed of rate hikes moderated (Figure 2).  As the pace of rate movements is likely to slow further this year—if not stop altogether—two overriding factors will likely continue to support credit spreads:

1. Increased interest in fixed income at the end of the rate hike cycle, which is already evident in positive retail flows into bond funds; and

2. Decreased odds of a hard landing due to the Fed’s more cautious pace of rate hikes.

Figure 2: Slowing Rate Hikes Should Continue to Support Spread Products like Corporate Bonds, Securitized Products and Emerging Market Debt (LHS in bps; RHS in %)

Source: PGIM Fixed Income and Bloomberg.

Bottom line: As the Fed’s rate hike cycle winds down this year, some upward pressure on long rates may be offset by improved risk appetite and credit spread compression, net-net creating a positive environment for the fixed income markets.

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Source(s) of data (unless otherwise noted): PGIM Fixed Income, as of June 14 2023.

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