Bank of America believes that pausing rate hikes in September will give the Fed time to assess the impact of a rapid policy shift without sacrificing too much in fighting inflation. A growing number of Fed officials will support a pause in rate hikes in September if financial conditions remain tight or deteriorate and future economic data continues to fall short of expectations.
With the subtle change in the Fed’s statement, the market is now betting that it will “slam the brakes” on interest rate hikes in September. Bank of America believes that once the Fed does, market risk will return and nearly all risk assets will move sharply higher.
The Fed’s latest meeting minutes showed that policymakers believe the monetary stance needs to shift quickly to more neutral and that “restrictive policy beyond neutral levels may become appropriate.” Most officials support 50 basis points of rate hikes over the next few times.
At the same time, the Fed’s forecast for its favorite inflation measure, the PCE price index, has fallen significantly, from 4.3% at the end of 2022 to 2.5% in 2023, and then to 2.1% in 2024. This would mean that the next three expected rate hikes of 50 basis points would mark the end of the current tightening cycle and set the stage for a major risk of a comeback in the second half of 2022.
Many participants believe that a sharp earlier rate hike would leave room for a pause later in the year to assess the impact of policy tightening. Traders also slashed their rate-hike forecasts for the Federal Reserve.
That shift in winds and market bets helped push stocks higher. On the last trading day of the week, U.S. stocks finally reversed their continuous decline. The S&P 500 and the Nasdaq rose more than 2% and 3%, respectively. The Nasdaq recorded the largest increase since May 13, and finally reached the fourth consecutive day for three consecutive days. The day collectively closed up.
U.S. Treasuries also rose, sending yields tumbling, with the five-year U.S. Treasury yield falling to 2.724% from a mid-month high of nearly 2.9%.
The suspension of interest rate hikes in September has become a “market consensus”
On Monday, 23rd local time, Atlanta Fed President Bostic said that Fed policymakers may pause rate hikes in September after raising rates by 50 basis points at each of the next two meetings:
I’ve got a basic take, and I think a September suspension might make sense.
As we get through the summer, we’ll think about where we’re at in terms of policy, and I think a lot depends on the actual dynamics that we start to see. My motto is to observe and adapt.
Bostic reiterated his support for Powell’s plan to raise interest rates by 50 basis points at the June and July FOMC meetings, warning that more aggressive action may be needed if prices unexpectedly rise.
Analysts said this was only the first hint of a Fed pause in rate hikes, and more signals are expected before the real “pause button” starts to hit. It is only a matter of time before Powell surrenders to the plan to “raise rates until the federal funds rate is well above neutral.”
Bank of America strategists said their long-held view of “the Fed pausing rate hikes” in September has now become the general consensus in the market.
Ralph Axel, rates strategist at Bank of America, wrote:
While markets are pricing in the Fed meeting or exceeding 3% in mid-2023, we have recently seen fragile but significant changes in the Fed’s communications with the public.
Some Fed officials have hinted at the option of slowing rate hikes or pausing when rates hit 2 percent later this year, given the challenging macro backdrop, tightening financial conditions and a potential softening in inflation.
Why in September?
On May 13, Cleveland Fed President Mester said:
If monthly readings on inflation by the September FOMC meeting provide convincing evidence that inflation is falling, the pace of rate hikes may slow, but if inflation fails to moderate, then it may be necessary Accelerate the pace of interest rate hikes.
She leaned toward a 50-basis-point rate hike at two meetings in mid-June and late July, and acknowledged the possibility of a 75-basis-point hike.
But Bank of America believes that the Fed has effectively opened the door to a pause in rate hikes in September, or it will reduce the rate of interest rate hikes to 25 basis points per meeting, and possibly even 25 basis points per quarter. With all options under consideration, Bank of America expects a growing number of Fed officials to support a pause in rate hikes in September if financial conditions continue to tighten or deteriorate and future economic data continues to fall short of expectations.
The Fed’s risk management approach to current policy is to call for the normalization of interest rate policy as soon as possible, but it also seeks to avoid a recession due to excessively high interest rates, preventing the neutral rate curve from slipping since the last rate hike cycle. Bank of America believes that pausing rate hikes in September will give it time to assess the impact of a rapid policy shift without sacrificing too much in fighting inflation.
Bank of America said there has been a marked shift in the Fed’s communication stance in recent weeks as financial conditions have tightened sharply, the economic outlook has deteriorated and the threat of runaway inflation now appears to have receded – the potential peak for the CPI peaked as early as March .
What will the interest rate level be?
Historically, the Fed paused for a year after its first rate hike in December 2015, as U.S. stocks entered correction territory in January 2016; Suspended again and made three emergency rate cuts in 2019.
But this time around, the Fed needs to normalize policy more fully before pausing rate hikes because inflation is so high. In their view, the normalization of interest rate policy, combined with the impact of the balance sheet reduction initiated in June, may mean that the neutral interest rate level reaches 1.75%-2%.
Bank of America sees the September pause in rate hikes as a combination of slowing job growth amid tightening financial conditions as long as inflation continues to decline slowly, although whether these factors will now dominate the September FOMC meeting. The suspension is still unknown. If the ensuing economic data remains weak and inflation continues to cool, interest rate markets are betting higher on the likelihood of a pause in rate hikes in September, meaning lower rates across the curve.
While there are “risks” in September as a market-focused rate hike point, inflation remains high, preventing the Fed from taking any action before then. Axel wrote that the June and July meetings are almost certain to raise rates by 50 basis points, which was reiterated in this week’s FOMC minutes. Ahead of the September meeting, the federal funds rate range will be 1.75-2%, at the bottom of the Fed’s long-term economic forecast range.
But Bank of America also believes that the actual neutral rate level, as a moving target, is not fixed: the market is currently pricing the neutral rate at 2.5%-2.75%, slightly higher than the current Fed median (2.4%) , but below the steady state of 2.75%-3% in 2016-2019.
Bank of America believes that the Fed can easily demonstrate that reaching 1.75%-2% means normalization of monetary policy, but not necessarily the end point of policy:
This will provide an opportunity to assess the impact on employment and inflation, both of which would need to fall over the summer for that to happen. While tightening may resume at a later date as the situation changes, a pause in rate hikes in September could lead to a sharp reopening in the interest rate market given that the Fed is currently pricing in year-end rates at 2.60%, compared to a peak of 2.87% in May. Pricing.
Bank of America forecasts that if the Fed pauses raising interest rates in September, the policy rate could hit 1.83% by then.
More specifically, assuming the Fed hikes rates by 50 basis points in both June and July, and doesn’t raise rates at all in September, BofA expects the Fed’s Overnight Index Swap rate for September to close at 1.83%; if the Fed chooses to raise interest rates by 25 basis points in September (which is also the basic view of Bank of America), the OIS in September should close at 2.08%; if the Fed raises interest rates by 50 basis points in September, the rate will stabilize at 2.33%.
Axel set his end rate target at 1.96%, between the September pause and 25 basis points of rate hikes, which he sees as a 50% chance of a pause. The main risk is strong CPI and wage data in the next two months, but this is increasingly unlikely.
Impact on interest rates and markets
If the Fed admits to a decline in its neutral rate level, it would not only reduce the likelihood of a rise in the Fed’s terminal rate target, but it would also overturn an increasingly popular notion in the market that the Fed needs to Achieving positive real policy rates, which in turn drives growth stocks soaring in value.
Currently, the Fed’s OIS rate is priced to peak at 2.9% in mid-2023 before stabilizing at 2.5%. Markets forecast the rate to rise by 6.1% and 0.2% in 2022 and 2023, respectively. In the context of the above-mentioned suspension of the interest rate hike cycle at around the 2% level, Bank of America has given different scenario forecasts based on the endpoint interest rate level in mid-2023.
Axel argues that this forecast would even change the forward target for the federal funds rate to produce the hypothetical outcome for the term rate shown. The key to all three scenarios is the endpoint rate, as that will be the main determinant of long-term U.S. Treasury yields — the 10-year and 30-year yields.
Bank of America believes that if the Fed does suspend interest rate hikes in September, it will trigger a resurgence of large-scale risks, and the endpoint rate level may be significantly lower. The extent to which the endpoint rate falls will drive the change in the interest rate curve. Depending on how the endpoint rates are repriced, the 2-year and 10-year Treasury yield curves could be steeper or flatter; but in either case, rates across the curve are significantly lower. This means that in the event of a pause in interest rate hikes, the long-term trend in 5-year U.S. Treasury yields should be a key indicator for the market to watch.
BofA also added that if the Fed does “capitulate” to raising interest rates, almost all risk assets will move sharply higher.
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