Fed Watch: In a Holding Pattern

For the second meeting in a row, the Fed did what was widely expected and kept the Fed Funds target unchanged at the November FOMC meeting. As a result, the trading range remains at 5.25%–5.50%, still residing at a more than 20-year high watermark. While the policy maker continues to keep its options open for another potential rate hike, as I’ve said many times before, we are either at or very close to the end of this rate hike cycle.

Against the backdrop of 525 basis points’ (bps) worth of rate hikes, the Fed has been presented with an economic backdrop that has proven to be far more resilient than anyone expected, but there is a “new” game in town: potentially tighter financial conditions due to the surge in Treasury (UST) yields, where rates all along the yield curve either hit or came close to hitting that 5% threshold.

Powell & Co. have apparently bought into the notion the aforementioned rise in UST yields may be doing their job for them. However, what I find fascinating is that financial conditions may not have tightened at all. The Chicago Fed’s National Financial Conditions Index has actually fallen (loosened) over the last couple of months. Why is this important? Because this Index is very broad and includes 105 underlying components and would theoretically not be skewed by just one or two factors.

Nevertheless, the Committee seems to have elevated a potential tightening in financial conditions as a monetary policy input. As a result, the question may turn to not whether another rate hike is in the offing, but how long will the Fed be “on hold.” And really, when you come right down to it, this is ultimately going to be the key question anyway as we head into 2024 and beyond. With only one more FOMC meeting remaining in this calendar year, the Fed does appear to be united in its stance that rates need to remain in this restrictive territory for the foreseeable future. Hence, the “higher for longer” theme I’ve been consistently emphasizing.

On that front, as I noted following the September Fed gathering, the expectation for rate cuts has been completely turned on its head. The money and bond markets have gone from discounting the possibility of a rate cut already occurring this summer to now not expecting a decrease in the Fed Funds target until about mid-2024. In addition, as of this writing, the implied probability still has Fed Funds around 4.50% by January 2025!

Whether or not another rate hike is “in the cards,” quantitative tightening (QT) continues unabated. The Fed continues on its mission to reduce its holdings of Treasuries and mortgage-backed securities (MBS) on its balance sheet. Although this means a tightening policy has essentially gone under the radar (much like the Fed had hoped), it is a part of the policy maker’s toolkit that should not be ignored.

The Bottom Line

Regardless of whether the Fed is now officially done or not from a rate hike perspective, the end result of this cycle will be that interest rates are now at levels a generation of investors has not witnessed before, potentially ushering in a rate regimen that harkens back to pre-financial crisis times. Against this backdrop, investors have a whole new dynamic to consider in their fixed income portfolio decision-making process.