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  • Writer's pictureEng Guan

Will The US Federal Reserve Hike Today?

Updated: May 4, 2023

This is the big question echoing at the back of many investors' minds. Today is the day FOMC announces its rate decision and gives a peek into what lies ahead. We started May with a mixed bag of readings. Manufacturing data for April came in above forecast while the job market showed further signs of slowing with job openings falling short of expectations. And the banking troubles continued from March amongst the smaller to mid-size regional US banks. Just over the weekend, First Republic Bank was bought over by JP Morgan after being taken over by FDIC. This is the fourth bank to bite the dust since March following the footsteps of Silicon Valley Bank, Signature Bank, and Credit Suisse.


The hikes are starting to break things as they always did in previous extended rate hike cycles. So with all these troubles brewing and uncertainty ahead, you see numerous market players thinking that Fed will take a hiatus from its incessant rate hikes today. How likely is this?


Current Market Rate Hike Expectations


Effective Fed Funds Rate Expectations (3 May 2023)
Effective Fed Funds Rate Expectations (3 May 2023)

This is a snapshot of what is being priced by the market as implied from where the Fed Funds Futures are trading (source: CME FedWatch Tool). So the market is telling us that they expect the Fed to hike rates by another 0.25% today bringing it to 5.25%, and that probability is more than 80%. But they also anticipate this to be the last hike for the year where the Fed will then pause in June and subsequently cut 0.25% in each of the last 3 meetings for the year and bring the rate down to 4.5% at year-end.


While everyone is entitled to their own view, for today's FOMC, the market is for the most part, rarely wrong when such a high probability is baked in this close to the meeting.


Core Inflation Is Still Way Above Comfort Zone


Core PCE Inflation YoY (Source: TradingEconomics.com)
Core PCE Inflation YoY (Source: TradingEconomics.com)

Inflation has undoubtedly been on the move down since its peak in early 2022. This is the good news. But the Fed's preferred measure of inflation, the core PCE inflation remains high at 4.6%. It is still a considerable distance away from their target of 2%. That is why in the previous meetings, they have always stressed that the battle with inflation is far from over yet. Of course, that can change if the economy deteriorates rapidly as a drastic drop in demand should force inflation to fall faster. But we are not there yet.


Fed's Credibility At Stake


It is debatable how much credibility Fed even has these days. But for sure they will want to restore it. The Fed's number one priority to bring inflation down because price stability is their primary purpose. And they already lost a big chunk of market's trust as they are instrumental in allowing inflation to run away in 2022 after injecting an unprecedented amount of money into the system in 2020 and then brushing aside inflationary signs as transitory in 2021. The recent banking furor have also effectively slowed the Fed's withdrawal of money from the system. And any signs that Fed is relaxing more than what the market expects might send bullish sentiments flying back up again. And that could potentially have the impact of reversing what they have achieved so far as what history has shown in the 70s.


Conclusion


So in my opinion, Fed is likely to push through with the 0.25% hike today. The number one threat is still persistently high inflation. But they are likely to soften their language from the previous meeting which market participants are looking out for. I doubt they will give clear directions. More likely than not, they will leave the future options open-ended and as usual dependent on data.


But the banking crisis is a wild card that will bear down on them. Even though they have separate facilities to tackle the banking issue and larger banks look safe for now, the money to maintain stability within the banking system came from the same source. So while you are tightening on the rates and money supply on one side, you are releasing on the other. That could impede the progress to bring inflation down.


In the event that the market (including me) is wrong and Fed pause today contrary to what most expect, that will be a much more dovish signal, and all asset classes are likely to fly today.


Stay safe and invest prudently with a well-diversified mix of assets and strategies!


 

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