Friday's Market Minute: Bank Tumult And The Fed Have Put Equities At A Crossroad

Jerome Powell and the FOMC are clearly concerned about the impact of recent events on financial conditions which may impact credit creation, slow the economy, and drag down inflation. Due to ongoing regional bank issues, financial conditions have tightened in a disorderly way, putting more pressure on the Fed to perhaps temporarily or even prematurely abandon their inflation mandate.

The risks of further bank fallout have certainly left equity investors anxious. While the Fed is not pricing in any rate cuts this year, the bond market signals a decline in rates by the end of the year. According to the dot plot set of economic projections, most Fed officials still see the federal funds rate peaking at between 5 and 5.25 percent this year, a quarter-point higher than the current level. However, two-year treasury yields at 3.8% suggests the Fed Funds rate is nearly 100 basis points above the implied short-term rates set by the bond market. According to data from the CME Group, the probability that the Fed would cut rates in July rose to 79% yesterday. Hence, there is clearly a disconnect between what the Fed projects rates will be by the end of the year and what the bond market and traders suggest rates should be.

From the standpoint of inflation, labor, and growth, the Fed expects a slight increase in the core PCE to 3.6% as well as the unemployment rate at 4.5% by the end of the year. Perhaps due to the tumult in the banking sector, the Fed slightly downgraded its outlook for the economy, which it expects to grow only 0.4 percent this year before expanding 1.2 percent in 2024. When piecing this data together, the Fed projects a soft landing when assessing their projection of a non-recessionary increase in the unemployment rate by 0.8 percent and GDP growth to glide along at 0.4 percent for the remainder of the year.

Despite all the market volatility this week, market watchers could interpret the FOMC decision this week to raise rates as confident support that the Fed views the recent bank woes as temporary and isolated, which is a good thing for those worrying about systemic failure in the banking system. Furthermore, the Fed hinted that a pause in rates may be coming soon, which is a piece of good news for investors. However, this doesn’t mean rate cuts are coming anytime soon, and the Fed has hinted it will do whatever it takes to get inflation back near 2%. Even if the Fed declares the end of the current rate hike campaign in May, volatility is likely to remain the name of the game.

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