The Fed’s willingness to shift on volatile data makes rate expectations difficult.
The Federal Reserve is taking the punch bowl away so quickly that rate expectations are sloshing around. They even spilled over following its extraordinary leak to the press during the customary quiet period ahead of its June Federal Open Market Committee meeting. The hint that a 0.75% hike was likely to follow put the fed funds futures market in a tizzy.
Communicating through the media is one of the most effective tools in the Fed’s toolbox, but doing so anonymously and so close to the start of a FOMC meeting is new. We will all have to be more cautious now about guidance. But it shows just how data dependent this Fed has become. Policymakers knew CPI would be high, but they didn’t like the jump in inflation expectations indicated by the University of Michigan consumer sentiment report.
While the aggressive rate move increased the probability of a recession, let’s not discount the possibility of a less-onerous pullback. “We’re not trying to provoke—and don’t think that we will need to provoke—a recession,” Chair Jerome Powell said in his semiannual testimony to Congress midmonth. It still is possible the Fed can tame inflation without overly damaging the economy.
This is borne out in expectations of how the tightening cycle might progress. The Fed just released the dates of next year’s FOMC meetings, allowing the first futures trading. The market is pricing in a peak at around 3.5% in 2023, with no action in the third quarter and a rate cut in the fourth of that year. You read that right. The Fed’s own projections are similar. Its median “dot” hits 3.8% before slipping to 3.4% in early 2024. We think the robust labor market, as well as strong state and local government balance sheets, means the economy is resilient enough that we might see a quarter of negative growth followed by one of positive growth in the second half of next year—not a full-blown recession. But things are dynamic and volatile. Ask us tomorrow and our answer might be different.
As the Fed’s quantitative tightening just began in June, the impact is negligible. We are disappointed that Treasury bills are not part of the strategy. They are being allowed to roll off the balance sheet only if the release of notes, bonds and MBS doesn’t hit the target of $47.5 billion exactly. That’s unfortunate not just for investors but in general. Use of the Fed’s Reverse Repo Facility has stayed north of $2 trillion for weeks now as market yields are miniscule. This has much to do with the high demand for short Treasuries as equities sell off, interest rates rise and the Russian/Ukraine war persists. But at some point the Fed needs to reestablish the market for overnight transactions between counterparties.
Deposit products continue to be a poor alternative. It is amazing how little that most bank rates have adjusted upward with the Fed action. Industry-wide, money market funds are tracing the rate increases. The Crane 100 Money Fund Index, the average of the 7-day yields of the 100 largest taxable money market funds, vaulted over the 1% mark in June, ending at 1.17% at month-end.
We have not changed our outlook or calls, keeping the Weighted Average Maturities (WAMs) of our money funds in the 25-35 day range.