Federal Reserve preview: will this be the final rate hike?
14:00, 28 April 2023
After an exciting week of earnings where US tech stocks have shown more resilience in their money-making capabilities than expected, attention will shift next week towards the Federal Reserve meeting, which will conclude on Wednesday, May 2nd.
Over the past 14 months, the interest rate has increased almost 500bps in the US, bringing it to the current range of 4.75% - 5%. This is the highest level since 2007, just before the financial crash that shook markets and created an imbalance between growth and inflation, that has remained until this day.
Once the rate hikes started to gather pace throughout 2022 we started to get used to them and believed they were necessary to tame the out-of-control inflation economies were no longer accustomed to. But two key questions have remained throughout this time: what will the terminal rate be and when will it be reached?
For the past 6 months, since inflation and growth started to show signs of slowing, analysts have been trying to predict the answer to these two questions, but as time has gone by and the Fed has remained firm in its mission to combat persistent inflationary pressures, the ability to make the right call has gotten harder.
But it does seem like, at present, there is somewhat of a consensus that the terminal rate is near. Some analysts expect the upcoming meeting in May to provide the last rate hike of this hiking cycle. Assuming, as markets are implying with a 90% probability, that the hike will be of 25 basis points, that will take the Fed fund rate to a range between 5% and 5.25%. That is currently the peak rate implied by markets, which are taking it a step further by suggesting that the FOMC will have to cut rates in the latter part of the year, with an implied rate of 4.5% by December.
Implied Fed rates. Source: refinitivIn all honesty, the economic data continues to offer mixed signals. It is clear that inflation and growth are slowing, as evidence by the recent CPI and GDP figures, but the labour market, which has been a key focus for the Fed in the last few months, continues to show resilience, which would allow the Fed to continue hiking gradually over the coming months.
In fact, if you listen to some recent commentary from Fed members, most notably Governor Christopher Waller, you would think that there is still a long way to go before the peak rate can be achieved, given “the Fed hasn’t made much progress on inflation’ and “rates need to rise further”. This was only two weeks ago. Buy one thing is for sure, the Fed has been adamant that they do not expect to cut rates in 2023.
Of course, that could have changed, and that is why aside from the rate decision next week, all the attention will be focused on Jerome Powell and what he has to say about the future path of interest rates, and whether their position has changed at all with regards to where rates will be in December.
Market reactions
It is likely that we see a increased volatility spread out across all sectors, but the bond market is likely going to see a lot of it, given expectations may shift if the Fed continues to stand by its prediction that rates will not be cut in 2023.
The equity market will likely also see some increased volatility but it has been slightly hard to determine the impact of rate decisions over the past few months. On the one hand, a hawkish Fed indicates that the economy is resilient enough to withstand continued tightness in financial conditions, which should be positive for the stock market, but it also increases the risk of a recession as consumers’ disposable income and spending capacity will be reduced, especially given the amount of tightening we have already seen in the past year, which would drag on stocks.
If we look at the past two decisions, in March, which caught stocks in the middle of a bullish recovery rally, the day of the decision saw a slight pullback the S&P 500, but overall the rally continued unaffected. In February, which was at the top of a rally’s the day of the decision saw a continuation of the upswing, but that eventually led to a correction in the following days. Given the current situation resembles more what we saw in February, as the recent rally in stocks has been slightly exhausted and we seem to be at the top of the uptrend, if the Fed remains hawkish at the meeting next week, we could see the pullback in stocks extend further.
S&P 500 daily chart
S&P 500 daily chart. Photo: capital.com. Source: tradingviewIn the FX space, the US dollar has been finding some support over the past few sessions as the latest data continues to point towards a resilient economy. If the Fed stays firm in its hawkish stance, and that is the feeling traders get from his press conference, then we may see the recovery extend further. For EUR/USD, for example, this could intensify the selloff, which has already broken below its spending trend line support, with a potential dip back towards 1.09. On the contrary, if markets believe that the Fed’s messaging has turned slightly dovish, then the USD strength will likely; y diminish, potentially pushing EUR/USD up towards 1.11.
EUR/USD daily chart
EUR/USD daily chart. Photo: capital.com. Source: tradingviewRelated topics