Evening Brief – 11.02.23

Is the Fed Done?

As widely expected, the FOMC decided to keep the Federal Funds rate unchanged in a range of 5.25% to 5.50% on Wednesday. The focus quickly shifted to deciphering the statement and Chair Jay Powell’s prepared remarks for any changes in the Fed’s reaction function.

While the Fed left the door open for another rate hike, many officials suggested that the rapid rise in US Treasury yields limits the incentive to tighten policy further.

Powell stated that financial conditions have “tightened significantly in recent months, driven by higher, longer—term bond yields, among other factors.” He repeatedly stated that the committee was proceeding “carefully,” a phrase that has often implied a low possibility of a policy adjustment, while also stating that risks to the outlook have become more two-sided as the tightening cycle approaches the finish line.

Quantitative tightening continues, with the curve steepening about 86 basis points since the end of June. Perhaps the bond market has done the FOMC’s work.

Powell maintained a tightening bias in the press conference, underlining the message that robust growth may merit “further tightening” and adding the FOMC was “not confident yet” that they had established a “sufficiently restrictive stance.” So, leaving the option of a December hike on the table while refuting the notion that it would be “difficult to raise again after a meeting or two.”

However, the price action after the meeting and today implies that traders are increasingly skeptical that the hawkish leaning will be realized. The US 10-year yield has fallen nearly 35 basis points since poking above 5% on October 19, stocks have continued their rally of the past four days, and WTI crude oil has dipped back to its early October lows.

The Fed is most likely done raising interest rates, but this will require further evidence of moderation in growth and labor market data (the increase in weekly initial jobless claims on Thursday helped), as well as financial conditions remaining tight or tightening further.

With Powell noting the continuation of tighter financial conditions as “critical,” one can’t help but wonder if the dovish market reaction (higher equities, lower rates) could inspire some hawkish pushback, especially if it persists.

At this point, the Federal Reserve needs to be convinced to hike again as opposed to being convinced not to hike. The latest Fed rate hike probabilities largely suggest no hike over the next three meetings, with a 19% chance in December; a 27% chance in January 2024; and 23% in March 2024, according to the CME FedWatch Tool.

As for rate cuts, the market is starting to get a little bold. The probability of the first cut is 28% for May 24, but it then jumps to 59% and 79% for June and July, respectively.