The Fed’s rate hike cycle: Out with a whimper

Analysis
Insights

The Fed’s rate hike cycle caused a commotion, but its possible end did not. What might it mean for fixed income investors?

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July 27, 2023

Thomas Garretson, CFA
Senior Portfolio Strategist
Fixed Income Strategies
Portfolio Advisory Group – U.S.

The annual July Federal Reserve (Fed) meeting can be one of the least interesting confabs on the calendar. It’s sandwiched between the June meeting, which features one of the quarterly updates to the Fed’s economic and rate projections, and the August Jackson Hole Economic Symposium, which the Fed has tended to use to deliver new initiatives, policy directions, or messages to the market.

This month’s meeting was no different. The 25 basis points (bps) rate hike, to a 5.25 percent–5.50 percent target range, was expected by just about everyone. There were barely any tweaks to the official policy statement. And Fed Chair Jerome Powell’s press conference? He took great pains to say absolutely nothing new while keeping all options going forward on the table, before making a notably brisk exit stage left.

When the Fed kicked off this rate hike cycle in March 2022 it was also with a 25 bps move amid an outlook for gradual rate hikes. At that time, policymakers projected rates would rise to just 2.75 percent by the end of 2023, just half of where they are now given what has transpired since.

How we got here

The evolution of the Fed’s rate hike cycle

The evolution of the Fed’s rate hike cycle

Chart showing how the pace of rate hikes has evolved since January 2022, from 25 basis point increments to as high as 75 basis points, and back. Over that stretch, the Federal Reserve has now delivered 525 basis points of cumulative policy tightening.

  • Rate hike size (LHS)
  • Cumulative rate hikes (RHS)

Source – RBC Wealth Management, Bloomberg, Federal Reserve; shows upper bound of Fed’s target range, bps = basis points

In some sense, it’s a bit anticlimactic that one of the most historic and closely watched rate hike cycles on record likely ended on such a note – no mission accomplished banners, no fireworks, and no parades. But we thought that was always going to be the case.

While another rate hike remains somewhere on the table – traders currently project just a 25 percent chance of another move in either September or November even after the events of this week – we maintain our view that the rate hike cycle is effectively over. Why?

Economic nirvana?

Late last year, Powell stated that while an economic soft landing was “still possible,” the path had “narrowed.” Now it looks like the Fed could land a 747 on it.

If there was one notable takeaway from this week’s meeting, it was that the Fed staff is no longer modeling a recession this year. And we think it’s easy to see why.

The first estimate of Q2 Gross Domestic Product growth released this week after the Fed meeting handily outpaced expectations, rising 2.4 percent on an annualised basis against consensus survey expectations of 1.8 percent. While at first glance that may appear at odds with the idea that the rate hike cycle is over, prices rose just 2.2 percent in Q2, well below the 3.0 percent consensus expectation. Growth without inflation – surely a welcomed development.

On top of that, the Conference Board Consumer Confidence Survey this week showed a similar dynamic – consumer confidence rose to a two-year high while consumer inflation expectations fell to the lowest level since November 2020.

Of course, given this kind of economic backdrop where consumers remain remarkably resilient, and perhaps more confident as the scourge of inflation fades, there will likely be an underlying risk the Fed will choose to abort the landing and proceed with further rate hikes before trying to land this thing again. But, we think downside risks for the economy will outweigh upside risks over the back half of the year as the cumulative impact of policy tightening on economic activity has yet to fully bite.

Plus, a wide swath of business surveys shows significant disinflationary pressures still in the pipeline, supporting our view that the bar for further hikes will be quite high, though truly dependent on the next two months of consumer price index and labour market data.

Investing nirvana?

Another rate hike paired with fading economic risks continues to be a boon for fixed income investors.

As the second chart shows, short-term yields – which are most sensitive to the Fed’s overnight policy rate – in most major fixed income sectors are unsurprisingly at or near the loftiest levels on offer in nearly 20 years with the Fed’s policy rate now at the highest since 2001.

The yield landscape has rarely looked better for investors

Current yields for three major U.S. fixed income sectors

Chart showing the current yields for three major U.S. fixed income sectors: Treasuries, Investment-Grade Corporates, and Municipals, sorted by average maturities. Short-term yields for each are near the highest levels of the past 18 years, while all maturities offer investors above-average yields over that same timeframe. Current yields for Treasuries: Short, 5.4%; Intermediate, 4.5%; Long, 4.1%. Corporates: Short, 6.1%; Intermediate, 5.4%; Long, 5.5%. Municipals: Short, 3.1%; Intermediate, 3.0%; Long, 4.2%.

  • 2005–2023 range
  • 2005–2023 average
  • Current yield

Source – RBC Wealth Management, Bloomberg Bond Indexes; excludes recessionary periods; munis do not reflect taxable-equivalent yields

Longer-term yields – which are more sensitive to the market’s outlook for economic growth and inflation – remain both lower than short-term yields and off the decade-plus highs but are still notably above average. The market’s inflation expectations have fallen back to more normal levels, dragging yields lower, but that has been offset to some extent by strengthening growth expectations and lower recession risks.

Given a resilient economy, we have pushed back our rate cut expectations to approximately the middle of next year, which should extend the timeframe that bond investors have to put money to work.

As such, we remain largely agnostic on yield curve positioning – with the Fed on hold, total-return performance across maturities should be broadly similar on a 12-month horizon.

However, we note that as most investors are likely keen to buy short-dated bonds and roll them over at maturity, we suggest investors begin to employ a gradual strategy over the next year of rolling those maturities into longer-dated bonds.

Locking in yields for longer, with the potential for capital appreciation should yields fall, has historically been the play between the last central bank rate hike and the first central bank rate cut. It is a window we believe we have now just entered.


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Thomas Garretson, CFA

Senior Portfolio Strategist
Fixed Income Strategies
Portfolio Advisory Group – U.S.

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