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  • Writer's pictureAllQuant

Who is right? Fed or The Markets?

Alright, the US Federal Reserve delivered the verdict yesterday. They hiked another 0.25% and that was pretty much what nearly everyone expected. There aren't many surprises. And as usual, they have kept their options open-ended by saying that their rate decisions will be guided by data. But, I would say they are a small notch more dovish than previously, although still more hawkish than what the markets would like.


Here are a few statements made in the session yesterday.


"The US banking system is sound and resilient. Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation." - FOMC Statement


This is a bit of a stretch in my opinion. 4 US banks have failed to date in a short span of a few months - Silicon Valley Bank, Signature Bank, Silvergate Bank, and First Republic Bank. And if we include Credit Suisse (non-US), that is the fifth. So I wouldn't go so far as to say it is sound and resilient as if nothing happened. And given how the stock market responded, in particular banking stocks, they don't seem to agree as well. But at the moment, yes, there seems to be no immediate threat to the larger boys and the broader banking system. It is the banks' bad liquidity management problem in a rising rate environment and the risk of large-scale contagion is not high. The second part of this statement does ring true though. With banks facing higher borrowing costs and likely more stringent regulations down the road, we will see tighter credit conditions ahead which will put a further headwind to the already slowing economy.


"We on the committee have a view that inflation is going to come down not so quickly. It will take some time, and in that world, if that forecast is broadly right, it would not be appropriate to cut rates and we won’t cut rates" - Press Conference


Again, they stressed that it will take time for inflation to come down to their target. Given the last core PCE inflation print of 4.6%, we can all see that. So what I took it to mean is that the US Federal Reserve may pause but they don't see rate cuts anytime soon. However, the fed funds and bond markets are expecting more than even before the FOMC. They are pricing in rate cuts as soon as July seemingly in disagreement with the Fed. See the before and after rate path chart below.



So who do think will end up being right?


Actually, there is no point second-guessing something which cannot be known because you might well end up asking the same question the next round and the next and the next ... The key is to have a sound and well-diversified investment strategy, then you should be able to ride through well.


 

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