Things will cost even more with this latest Fed move

Stocks rallied yesterday after the Fed raised its key lending rate by +75 basis points because it could have been worse. Retail Sales slipped unexpectedly last month leaving investors wondering if the economy is about to slow down.

Pop ‘till you drop. The Fed is at the helm of monetary policy which, these days at least, puts it in control of the economy and the financial markets. So, you can say, it is important to understand what the central bankers are up to. If you want to know, all you have to do is ask. Yesterday, the FOMC decided to hike its Fed Funds rate by +75 basis points. I am sure you know by now, because even the local news carried the headline. The rate hike, however, was only one small part of a bigger story. As highlighted here in my morning note yesterday, the +75 basis point hike was largely expected by the financial markets as evidenced by futures and forward rates. Furthermore, last week’s blistering CPI number is still very much in the minds of investors. In, fact some investors were expecting a full 1-point hike yesterday. So, it is safe to say that investors were prepared for the worst, and what they ended up with was not the worst-case scenario. The markets initially reacted in a slightly positive manner, but once the Fed Chair held his press conference stocks rallied. Though the rate hike may have been a bitter pill to swallow, Chairman Powell attempted to ease the blow with words.

Powell reiterated the oft-used line that the Fed was data dependent and that the recent uptick in inflation called for a more aggressive, upfront hike. He also noted that he didn’t expect hikes of this magnitude to become the norm – stocks liked that and rallied. He then went on to say that he expected that rates were likely to be hiked by another +50 to +75 basis points in the next meeting. Because markets have already factored in another +75 basis point hike, Powell’s suggestion that perhaps a +50 basis point hike may be in the offing caused bond yields to pull back and stocks to rally further. The goal, as Powell put it, was to get to the neutral rate (which most, including Powell believe is around 2.5%) as quickly as possible to enable the Bank to have optionality. What that means is that at 2.5%, rates should not have a materially negative effect on economic growth, but once the Fed gets there it can slow down its movements in response to the conditions at the time. In plain English, the first 2.5% is analogous to moving your foot off the accelerator and on to the brake pedal. Anything beyond would be applying the brakes, which could mean a light tap if things look like they are improving, or perhaps, a stronger press if things are not. Though the Fed made it clear that it is strongly committed to getting inflation back to its 2% target, Powell’s description of the process hardly painted a picture of a panicked, catching-up central bank. All that sat well with investors which allowed market gains to hold into the close. Though most focused on the calming talk, there were some numbers to consider as well.

The Fed released its Dot Plot along with its economic projections. Both of those detail the individual expectation of each FOMC member, so we can utilize the medians to get an idea of what to expect in policy going forward. So, let’s take a look at what clues the Fed gave us in its projections. Real GDP is expected to end the year at +1.7%. So, members are not expecting a recession, but the number was revised down from its +2.8% expectation from March. Further, the Fed is projecting +1.7% growth next year and +1.9% for 2024 – no recession, but also revised downward from March’s projections. Unemployment, according to median projections is expected to pick up in 2023 and 2024, both revised up. The uptick is only slightly higher than the current 3.6% and right around the longer-term average. Finally, on to reason for all this fuss: inflation. The Fed is expecting PCE Inflation to end the year at +5.2%, slightly higher than it is now. That number was revised upward from March’s survey and the Fed expects it to recede to +2.6% by the end of 2023 and +2.2% by the end of 2024. Finally, on to the Fed’s interest rate projections. The Fed expects Fed Funds to close out this year at 3.4%, revised upward from its 1.9% March projection. 2023 will end up with a 3.8% Funds rate and 2024 with 3.4% -- all revised upward from March’s projection.  Focusing on this year, it looks like we will get 2 more +75 basis point hikes… or possibly a single +75 basis point hike followed by a +50 and a +25… or any other permutation. Here is the good news if you could call it that. The market has already factored in a 3.6% Fed Funds rate for the end of the year. Here is the good or bad news, depending on how you interpret it. Consumers are already spending less, as evidenced by yesterday’s negative Retail Sales surprise, so the weaker demand may lead to lower prices – good interpretation. A pullback in consumption can also lead to a recession if it becomes pervasive – bad interpretation. In summation, the Fed raised its key lending rate by +75 basis points, the largest hike since 1994, and it revised its 2022 economic growth forecast downward, its unemployment rate forecast upward, and its interest rate expectations upward. I will leave it to you on how to interpret that.

YESTERDAY’S MARKETS

Stocks spent the day preparing for and reacting to the FOMC release, closing in the green. The S&P500 gained +1.46%, the Dow Jones Industrial Average climbed by +1.00%, The Nasdaq Composite Index jumped by +2.5%, and the Russell 2000 Index advanced by +1.36%. Bonds gained and 10-year Treasury Note yields fell by -19 basis points to 3.28%. Cryptos gained +0.58% and Bitcoin fell by -1.48%.

NXT UP

• Initial Jobless Claims (June 11) is expected to come in at 217k, down from last week’s 229k claims.
• Housing Starts (May) are expected to have declined by -1.8% after falling by -0.2% in April.
• Building Permits (May) may have declined by -2.5% after pulling back by -3.0% in the prior month.