Federal Reserve expected to slow hike to 25-bp, expect tough talk from Powell

Traders widely expect the Federal Reserve to slow its pace of rate hikes to 25 basis points on Wednesday, from its 50-bp increase in December following four back-to-back 75-bp hikes, as it assesses the impact of the tightening already in place.

With that, investors will be be attuned to signals for when the policymakers expect to end their tightening. Chairman Jerome Powell, though, is likely to push back against market expectations for rate cuts later this year, say some strategists and investors.

The CME FedWatch tool, based on 30-day fed funds futures pricing data, puts a 98.2% probability of a 25-bp increase, bringing the federal funds rate target range to 4.50%-4.75%. The Fed’s rapid tightening, which started in March 2022, is intended to reduce demand for goods and services, bringing demand more into balance with supply, thus easing inflationary pressures.

Recent economic data shows that inflation has decelerated over the past few months, evidence that the rate hikes are starting to work. Still, inflation remains well above the central bank’s 2% goal. On Friday, core PCE inflation, the Fed’s preferred measure, rose 4.4% Y/Y in December.

Matt Freund, co-chief investment officer and head of Fixed Income Strategies at Calamos Investments, expects between two and four more rate hikes ahead with the terminal rate being between 5% and 5.5%. “They’re going to be waiting for those lags to kick in to see the impact of what they’ve done,” he said.

José Torres, senior economist at Interactive Brokers, says, “the central bank appears far from declaring the end of monetary policy tightening. Prices for goods decreased a considerable 0.7% but prices for services accelerated to 0.5% m/m, the fastest pace since September.”

Morgan Stanley strategists headed by Chief U.S. Economist Ellen Zentner consider it unlikely that the Fed will signal an end to the tightening cycle, “but softer data flow over the next six weeks should move the Fed towards a pause.” They expect the Fed’s guidance for “ongoing increases” to be replaced by “further increases.”

The Morgan Stanley strategists see the policy rate peaking at 4.625% at this meeting, assuming that nonfarm payrolls and CPI prints reflect “moderate” inflation, “enabling the Fed to pause.” From there, they expect steady rates until December 2023.

While the federal funds futures market expects a 25-bp rate hike (most comments made by Fed officials in the past month also support that), there is a very small chance (1.8%) that the policymakers raise the rate by 50 bp again. In that case, expect the stock market to slump and long-term Treasury rates to climb. The 10-year Treasury rate was just under 3.53% Tuesday afternoon. “You’d see a lot of adjustments across all the markets,” Calamos’s Freund said.

Many of the recent Fed official remarks expect the terminal rate to exceed 5%, with none indicating a willingness to cut for the rest of the year. Early in January, Minneapolis Fed President Neel Kashkari said he sees the rate rising to 5.4% before pausing.

Markets though aren’t reflecting that. SA contributor Michael Kramer of Mott Capital Management pointed out that financial markets have eased to levels not seen since the Spring of 2022 and may force the Fed to push back on the market’s dovish stance.

With fed fund futures pricing in rate cuts before the end of the year, Freund expects Chair Powell’s comments to be “fairly stark and fairly non-supportive” due to the market’s disparity with the Fed’s messaging.

SA contributor Logan Kane says traders “are clamoring for a pivot,” while the Fed has given no indications of rate cuts this year. He expects cash will soon “pay 5% risk-free, and is actually the best hedge against inflation going forward.”

Calamos’s Freund emphasized the uncertainty of the economic outlook. While many economists are expecting a short and shallow recession, “I don’t think it’s an ‘and’, I think it’s an ‘or’,” he said.

There’s a number of things that can go wrong, such as a problem with the bond market functioning or stress on a financial intermediary, that could lead to a deeper recession. In that case, Freund thinks the Fed would reverse course quickly. “The alternative is that it is going to be very shallow” and grind on, he said.

SA contributor Chris Lau looks at five considerations after the Fed’s first rate hike of 2023