International | Jun 20 2023
Don’t let drama over next few Fed meetings distract from the big picture: Western Asset
-The Federal Reserve (Fed) will keep rates on hold for now, leading many to anticipate hikes at future meetings
-We think that distracts from the realities of the long-term outlook, notes Western Asset
By John Bellows, Portfolio Manager, at Western Asset, part of Franklin Templeton
At the June 14 Federal Open Market Committee (FOMC) meeting the Federal Reserve (Fed) left rates unchanged but kept alive the possibility of raising rates again at upcoming meetings. Arguably, the committee even leaned into the prospect of higher rates, as a majority of officials now forecast at least two more rate rises in their base case.
Over the past few weeks, there has been a fair amount of drama surrounding this possibility.
The amount of drama surrounding whether the Fed raises rates again at one of the next few meetings seems disproportionate to its importance. The big picture is unlikely to change materially whether the Fed ends its hiking cycle now or after one or two more rate rises.
Here we summarise how we see the big picture, and in our conclusion, we also offer a possible scenario as to how the drama will be resolved over the coming weeks and months.
The size of the possible future rate rises is small relative to the hikes already made. Indeed, the difference is a full order of magnitude: the Fed has raised rates 500 basis points (bps) to date, as compared to another 50 bps of possible rate rises that are reflected in the median projection of FOMC participants.
In terms of surprises relative to expectations, which is often what matters most for financial markets, the difference is even starker. The upside rates surprise in 2022 was one of the largest on record, corresponding with the worst year in the last 150 years for returns on US Treasury bonds.(1) If the Fed were to raise rates again now, in contrast, the surprise would be much more modest, as markets already reflect some probability of such an event.
While most of the rate rises are likely in the past, the full impact of monetary tightening is likely still ahead. In part this is due to the oft-repeated observation that monetary policy has “long and variable lags.”
There is another factor, however, that may be just as important in the current environment. The Fed plans to hold interest rates above 5% for the coming few quarters, while inflation is expected to decline over the same period. Consequently, real interest rates are expected to continue increasing even if nominal rates do not.
Fed officials are taking note. According to their own forecasts, a restrictive level of rates today will be even more restrictive a few months from now, with the economic impacts increasing as a result. This should give pause to any attempt to calibrate policy based on a handful of data prints.
Elevated funding costs challenge sectors of the economy that rely on leverage. In certain instances the resulting stress contributes to nonlinear developments, which in turn raises uncertainty and exacerbates downside risks. The turmoil in regional banks is the most recent example. While the stability in this sector over the past few weeks has been encouraging, the risks have certainly not gone away. It’s notable that regional-bank equities still trade at a discount of more than 30% to their February prices. More broadly, the environment remains challenging.
As long as funding costs remain above the rate of return on high-quality investments, banks will struggle to provide credit to the economy. Tighter lending standards is the minimum that should be expected, with risks tilted toward additional unforeseen stresses.
In summary, the following three points constitute the big picture. First, any future rate rises are likely to be small relative to the rate hikes already done. Second, the full impact of the rate rises has yet to be felt, as it will likely increase in the coming quarters when real interest rates increase further. Finally, the stress caused by elevated funding costs is significant and likely to continue. None of these considerations will change much, if at all, should rates end up closer to 5.5% instead of at their current level. The big picture is already set; the die has already been cast.
While it may not affect the big picture, the Fed’s actions over the next few FOMC meetings will undoubtedly receive a lot of attention, so here we’ll offer a view on the most likely outcome. We expect the upcoming economic data to provide further evidence of slowing growth and ongoing disinflation. The consumer price data released yesterday was somewhat mixed with regard to inflation last month.
Going forward the trend will likely be clearer: the decline in shelter inflation is set to continue, while the recent rise in goods inflation is likely to reverse, leaving core inflation broadly lower on net. The last few months of slowing labor demand is also likely to continue, as indicated by the forward-looking business surveys. On their own these trends may not cement a Fed decision.
Taken together, however, we expect they will be enough to forestall the Fed from raising rates as much as indicated in the FOMC projections.
Endnotes:
- Source: Zweig, J. “It’s the Worst Bond Market Since 1842. That’s the Good News.,” The Wall Street Journal, May 6, 2022.
About Franklin Templeton
Franklin Resources, Inc. [NYSE:BEN] is a global investment management organization with subsidiaries operating as Franklin Templeton and serving clients in over 155 countries. Franklin Templeton’s mission is to help clients achieve better outcomes through investment management expertise, wealth management and technology solutions. Through its specialist investment managers, the company offers specialization on a global scale, bringing extensive capabilities in fixed income, equity, alternatives and multi-asset solutions. With offices in more than 30 countries and approximately 1,300 investment professionals, the California-based company has over 75 years of investment experience and approximately AUD$2 trillion in assets under management as of April 30, 2023.
For more information, please visit https://www.franklintempleton.com.au/
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This publication is issued for information purposes only and does not constitute investment or financial product advice. It expresses no views as to the suitability of the services or other matters described in this document as to the individual circumstances, objectives, financial situation, or needs of any recipient. You should assess whether the information is appropriate for you and consider obtaining independent taxation, legal, financial or other professional advice before making an investment decision.
Please read the relevant Product Disclosure Statements (PDSs) and any associated reference documents before making an investment decision. In accordance with the Design and Distribution Obligations and Product Interventions Powers requirements, we maintain Target Market Determinations (TMD) for each of our Funds. All documents can be found via www.franklintempleton.com.au or by calling 1800 673 776.
Issued by Franklin Templeton Australia Limited (ABN 76 004 835 849, AFSL 240827). Franklin Templeton Australia Limited as Responsible Entity has appointed Western Asset Management Company Pty Ltd. as the fund manager of the Western Asset Australian Bond Fund (ARSN 886 702 86).
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