• Fed holds overnight rate range steady at 5.25% – 5.5%.
• Retains assessment that “the economic outlook is uncertain.”
• No cuts until “more confident of inflation reaching 2%.”
• Projects fewer rate cuts in 2025.

Wait and see

Today, the FOMC left short-term rates unchanged for the fifth meeting in a row. Short-term rates remain at a two-decade high, affecting borrowing of all types. January’s press release removed the bias toward higher rates. That spurred Wall Street’s run toward more rate cuts than the Fed projected for the next month and half. Today’s statement tempered rate cut hopes by stating that it will not be appropriate to cut rates “until (the Committee) has gained greater confidence that inflation is moving sustainably toward 2 percent.” The Quantitative Tightening program of letting Treasury and mortgage bonds roll off the balance sheet will continue at the same pace. 

Rates

By leaving the “greater confidence that inflation is moving sustainably toward 2 percent” phrase in place, the Committee is telling us that, yes, the next move will be to lower short-term rates. As the Committee left this year’s projection of three cuts in place, Wall Street ramped up odds of a June 12 rate cut today from last Friday’s 50% chance to 67% as we went to press.

We remind our readers that the futures markets, like the Fed economists, consistently bet wrong on timing of rate moves. The Fed historically has not reduced short-term rates until the annualized growth rate of nominal Gross Domestic Product falls below the Fed Funds rate. Most readers are familiar with “real” GDP, which is just nominal GDP minus inflation.

Nominal GDP grew last quarter at a 5.8% annual rate. This quarter, real growth appears slowing toward 2.1%. Add 3.2% inflation from the Consumer Price Index, and back-of-the-envelope nominal growth will have fallen down to the average Fed Funds level of 5.33%. This may be one reason why Powell suggested that “rate cuts may be appropriate later this year.”

Economic outlook

Speaking of growth, the economy is rolling along in second gear. Recent data supports our view that the economy is slowing this quarter and into the next. Recession is not in our base forecast this year or next. The Fed staff seems to agree, having bumped their GDP forecast from 1.4% this year to 2.1%. That approaches our 2.5% forecast for 2024. Possibly acknowledging their inflation road will not be smooth, the inflation forecast was raised from 2.4% to 2.6% for this year and does not reach 2% until 2026. 

Rate confusion

Treasury bonds reacted differently up and down the maturity stack. Raising the inflation forecast should push the entire Treasury yield curve higher. Instead, during the Chairman’s press conference, the curve Bull steepened. Two-year rates fell at least seven basis points while tens barely budged at two basis points lower. Longer rates were unchanged. A steeper curve where the shorter maturities fall more than longer maturities imply rate cuts. When might cuts happen? July or closer to the election? Chairman Powell stated that rate decisions are made meeting by meeting, depending on economic data. He has said that a number of times over the years. However, almost as an afterthought, he said that there could be an inter-meeting decision. That created some confusion among traders.

The Committee apparently is discussing steps to reduce its Quantitative Tightening program. Remember this is the program to buy fewer Treasury and mortgage bonds each month. In its current form, the program has reduced the Fed’s balance sheet by nearly $1 trillion. The balance sheet traditionally sits near the level of currency in circulation, currently around $4.5 trillion. At $7-plus trillion, the Fed’s QT program has at least a couple more years to run to return the balance sheet to “normal.” Powell stated in his press conference that the Committee’s view is that will be appropriate to slow the pace of reduction “fairly soon.” 

Summary

Markets now project July as the likely date of a first cut if the economy continues slow. We still believe most of the cuts come after election day and into 2025.

Last Saturday marked the two-year anniversary of the Fed’s current rate hike cycle. The Committee believes the current level of rates is the peak for this cycle. Economists think rate increases take around a year to a year and a half to work their way through the economy. If so, then the full effects of the Fed’s rate campaign are finally slowing consumer spending and lowering sentiment.

Inflation remains an issue, and we believe it troughed last year and will remain in the 3% area. The easiest path to reach the Fed’s magic goal of 2% is to have a “hard landing” recession. Given the amount of spending by the administration this election year, we ascribe low odds to a recession.

Please let us know how we can help you.

Steve Orr is the Executive Vice President and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. Steve has earned the right to use the Chartered Financial Analyst and Chartered Market Technician designations. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary’s University School of Law. Follow him on Twitter here. 

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