A difficult pivot for the Fed

Chairman Powell is expected to corral the cats and get the Federal Open Market Committee (FOMC) to skip a rate hike in June, while leaving the door open to hike in July. The rationale will be to assess the impact of earlier rate hikes and the additional tightening emerging in the banking sector.

Look for the Fed to revise up its trajectory for interest rate hikes in the Summary of Economic Projections. The signal will be higher rates for even longer. Financial markets are pricing in an 80% chance of a July rate hike. The problem is thereafter. Financial markets continue to price in rate cuts and a return to where we were before the Fed started hiking rates. That is not only contrary to the Fed but just about every forecast I have seen on the U.S. and global economy.

The Fed will couch the “skip,” as it now wants to refer to it, as a moment to assess the effects of earlier rate hikes and the additional tightening in the pipeline. The recent Beige Book for May revealed tightening of credit conditions above and beyond the tightening we have already seen in the Fed’s Senior Loan Officer Survey in the fourth and first quarters; those were already consistent with a recession.

Separately, the Treasury is poised to catch up on its debt issuance now that the debt ceiling has been lifted. This is at the same time that the Fed is reducing instead of increasing its balance sheet. Liquidity in the Treasury market, which is the backbone of the overall financial system, could be stressed and rates could spike as that occurs. Watch for more flows into money market funds if that occurs.

We now expect the fed funds rate to rise from its current 5.0% - 5.25% range to 5.5%-5.75% range by year-end. Resilience in the labor market and persistence in service sector inflation are expected to delay rate cuts until the spring of 2024. Even then, rate cuts are expected to be slower and less aggressive than hikes have been.