It is becoming clear that the Federal Reserve is getting close to the end of its interest rate hiking cycle. Over the past 14 months the Fed has increased short interest rates 10 times, at an unprecedented pace, hiking rates 500 basis points in an attempt to control spiking inflation.

In the recent Fed policy statements, officials hinted that another 0.25 percent hike had a high probability of being the last. However, the Fed chose to skip hiking rates in the June meeting, giving them time digest the impact of higher interest rates on inflation and economic activity. Surprisingly, they are now hinting that two more hikes may be needed before the campaign is concluded. Inflation is abating, but perhaps at a slower pace than the Fed would like. We think the Fed will hike only one more time in July, then take a long pause, holding rates steady until late in the year. Then, if inflation data have eased sufficiently, the Fed will pivot and begin cutting rates.

Market dislocations

The bond market suggests that the Fed is near the end of its hiking cycle. Short-term yields are pricing in a 0.25% hike in July. Longer-term yields have been in a trading range, with 10-year Treasury yields stuck between 3.4 and 3.8% over the past year. The yield curve is signaling lower inflation and slower economic growth.

If the Fed executes a skip, hike, and pause strategy, short rates may increase, however we don’t think longer yields will change materially. There is evidence to support this forecast. Both Australia and Canada exercised a skip, then hike strategy this year. Investors concluded the moves to be dovish as long-term yields fell slightly. Markets are looking at longer-term policy trends and reflecting that in market pricing.

The stock market is sending a different message. Risk-based assets appear to be complacent about the interest rate outlook. Year to date, the S&P 500 is up 15%, disregarding higher interest rates, sticky inflation, debt ceiling drama, and a potential recession.

A corporate earnings recession started late last year. Fourth quarter 2022 earnings were down 4%. The earnings contraction has continued in the first quarter of 2023 and we expect earnings growth to stabilize in the second half of the year. Last year the market telegraphed an economic and earnings slowdown. Stock prices bottomed in October of 2022, down 25% from the beginning of the year.

We believe the equity market is fully expecting a skip, hike and pause approach from the Fed. We expect equity returns to be in the 8-15% range for the calendar year. However, we know corrections are a normal and healthy part of the market cycle. Over the last 43 years, the S&P 500 has averaged a -14% intra-year decline. Therefore, we expect some type of correction this year.

What this means to investors

We think the Fed will decide to hike short-term rates 0.25% one last time in July. This should not have a significant impact on the markets. We firmly believe that inflation expectations and economic activity will drive both the bond and stock markets. 

Cash and cash equivalents are now a viable asset class. With money market yields close to 5% and short-term Treasuries yielding 5.25%, investors can reduce risk while earning an attractive rate. If the Fed hikes once again this summer, money market yields will move even higher.

Once the Fed pauses and the narrative changes late in the year to pivoting, moving rates lower, our fixed-income strategies will extend portfolio duration.  As interest rates decrease, longer-term bonds will perform well.

History shows that risk-based assets, such as stocks, perform well during a Fed pause period. Therefore, our asset allocation strategies are currently positioned in a neutral posture. We will look for opportunities to increase risk-based assets as the pause phase unfolds.

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