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Market Update

The hawks are back despite government default uncertainty

May 30, 2023


Many Federal Reserve members are signaling to the market that the fed funds terminal rate may need to be higher than prior FOMC projections suggested. They are also communicating that fed funds cuts will not occur until at least 2024. On the news, interest rates rallied despite economic uncertainty persisting around debt limit negotiations.

Federal Reserve minutes from the May 2 meeting were released last week. The minutes showed that market respondents expected a peak rate of 5.25%, 25 basis points above the current fed funds rate, and expected the peak to be maintained through the January 2024 meeting. FOMC members themselves were a bit more mixed. The members’ forecast for core inflation increased, but the minutes showed officials were less certain about future rate hikes. However, after three weeks of additional economic data, it appears the rhetoric from Fed members since suggests a rate hike in June seems much more likely. In separate instances, several Federal Reserve officials have been indicating additional rate hikes are warranted due to stubbornly high core inflation. The highlights of their recent announcements are below:

  • St. Louis Federal Reserve President James Bulliard — May 22
    • “I think we’re going to have to grind higher with the policy rate in order to put enough downward pressure on inflation and to return inflation to target in a timely manner.”
    • He went on to directly say he thought two more rate hikes were necessary, ideally sooner rather than later.
  • Minneapolis Fed President Neel Kashkari — May 22
    • "What’s important to me is not signaling that we’re done."
  • Dallas Fed President Lorie Logan — May 23
    • Told markets inflation remains “much too high” and suggested another hike was certainly on the table at the next FOMC meeting.
  • Atlanta Fed President, Raphael Bostic — May 24
    • “My best case is that we won’t be thinking about a cut until well into 2024.”
  • Federal Reserve Governor Christopher Walker — May 24
    • "I do not support stopping rate hikes unless we get clear evidence that inflation is moving down towards our 2% objective."
    • "Prudent risk management would suggest skipping a hike at the June meeting but leaning toward hiking in July based on the incoming inflation data."

In addition to the Fed members’ communications above, economic data released Friday suggested the economy is remaining persistently strong. Personal income grew 0.4% month over month and 5.4% year over year. Personal spending, in part due to strong income growth, increased 0.8% month over month and 6.7% year over year. Meanwhile, Core PCE showed inflation accelerating in April. Month-over-month core PCE increased 0.4% in April versus 0.3% in March. Year-over-year it increased 4.7% in April versus 4.6% in March. All these data points increased relative to their March readings and beat market expectations, suggesting the economy is not slowing down.

In response to Federal Reserve comments and strong income, spending, and inflation data, the market rapidly adjusted its rate expectations for the Federal Reserve.

Based on CME futures, the graph above shows that the market shifted its rate forecast up by about 62 basis points for its September 2024 Fed Funds rate prediction. The 62-basis point shift occurred in two weeks based on the incoming economic data and Fed commentary.

Notably, the market went from an expectation of a 460 basis point fed funds rate in December 2023 on May 15 to a 515 basis point fed funds rate in December 2023 by May 30. That implies the market rapidly changed its stance on when the first rate cut would occur. Unlike in mid-May, the market is starting to align itself with the Fed that rate cuts will be delayed until 2024.

In addition to Fed commentary, the market is very focused on the debt limit. A deal was reached between President Biden and House Speaker Kevin McCarthy over the weekend. However, many Democrats and Republicans within Congress have expressed their disapproval. Several key members within both chambers could delay the passage of the bill, especially those on the House Rules Committee. Unfortunately, any delay could result in a government default, since the government is expected to run out of money by June 5 based on the most recent update from Treasury Secretary Janet Yellen.

Assuming a debt limit is passed on time, corporates should remain mindful of additional shifts in interest rate expectations. The Fed has become increasingly hawkish lately in response to persistent core inflation, which has led rates to dramatically rise. With no clear end in sight for inflation, the current situation is particularly important for corporates thinking about issuing new debt. Relative to 10 weeks ago, the swap-to-fixed rate on a 5-year derivative contract effective September 30, 2023, and maturing on September 30, 2028, has increased roughly 49 basis points from 2.93% to 3.42%. Corporates should consider if they are able to withstand such large rate movements, especially if debt issuance is likely within the next 12 months. If they cannot withstand potential 50-basis-point swings, derivative contracts are a useful alternative.

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