Food for thought from the Fed

The Federal Reserve minutes for meetings held on the 3-4th May were released last night, and for markets that have been beaten up by rates volatility, they provided some interesting takeaways.

On the economy, the minutes revealed expectations that GDP growth would "rebound in the second quarter and advance at a solid pace over the remainder of the year". Meanwhile, although the Fed expects US GDP growth to slow in 2023 and 2024, it is likely to "remain well above potential over the projection period". The minutes also acknowledged that inflation would remain high but outlined predictions that PCE price inflation would fall to 4.3% this year and to 2.5% and 2.1%, respectively, in 2023 and 2024. Nevertheless, we should remember the Fed has a history of overly optimistic price predictions. 

However, the Fed's projected path of rate hikes, predictably, was the most interesting section for participants. Accordingly, Fed members were less hawkish than in recent meetings. Indeed, while two 50bp hikes seem pretty certain at the mid-June and late-July meetings (taking the upper bound to 2%), the minutes hinted that the Fed could pause afterwards, stating: "Many participants judged that expediting the removal of policy accommodation would leave the Committee well positioned later this year to assess the effects of policy firming and the extent to which economic developments warranted policy adjustments". 

The rate path is certainly higher, with the median survey from respondents expecting the midpoint target rate to peak at 3.13%. However, a pause at 2% would be somewhat of a surprise; the Neutral rate (i.e. neither accommodative nor restrictive) is probably around 2.5%. Moreover, given the need to lower inflation, we would expect the Fed to continue hiking before pausing when interest rates reach 2.5%. Of course, any pause would be data dependent, but given the hawkishness of Fed voters recently, even the suggestion of a break would provide relief for Treasuries and credit.  

These comments come at an interesting time for markets, as they coincide with important insights on the health of US consumers that suggest recent pessimism might be overdone. We think that the large US banks probably have the best insight into the health of the US consumer, as they service all cohorts of the population and all sectors. Therefore, comments from Bank of America (BoA) CEO Brian Moynihan stating that BoA's customers are yet to spend significant stimulus money, possess higher deposits than a year ago and are spending more, support the view that the US economy remains relatively healthy. These comments followed the JP Morgan CEO, Jamie Dimon, saying that the US economy remained strong and "credit looks really good". The sources of these comments are well-regarded and mean investors have reason to reconsider the growing view that the US economy was heading for a hard landing. For completeness, the Fed minutes also noted that "borrower credit quality continued to be strong overall", credit remains widely available, corporate default rates are very low, and rating migrations are still positive.

For market participants increasingly worrying about a US recession and the uber hawkishness of the Fed, the recent minutes and consumer robustness provides some points to ponder, especially as both rates and credit markets have been affected by poor investor sentiment. As we mentioned before, this is unusual and when correlations re-emerge, it is often followed by a relief rally. Whether this materialises or not probably depends on the direction of fund flows, but based on the threadbare dealer inventory, ample supply won't necessarily meet positive flows, potentially leading to higher prices.