FED may be finally looking at a rate halt

Fed minutes hint at a rate pause

When the US Fed published the minutes of the May FOMC meeting on 24th May, the big news was that the minutes indicated at a likely pause by the Fed. In May, the Fed had hiked its benchmark rate by 25 bps, taking the benchmark rate to 5.00% to 5.25%. The theme of the May policy was still inflation control, but the minutes suggest that members were veering more towards the pragmatic than towards the hawkish. Even as the stance of the Fed is still hawkish, the minutes are suggesting that the US could be close to the top. That is not surprising considering that there is a slowdown in GDP growth and a simmering banking crisis in the US. Pragmatism could rule the Fed stance in the coming months.

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Clustering of rate expectations in future

The CME Fedwatch allows readers to evaluate the probability of rate hikes or rate cuts over the next one year. Given below is a clustering of such probabilities.

Data source: CME Fedwatch

What does the cluster table above tell us about market expectations on the trajectory of rates going ahead post the minutes?

• The markets are suggesting that there could be a likely 25 bps rate hike and an outside possibility of 50 bps from here. However, the probability of a pause in June has now increased to 67%. Rate hikes may happen after that. 
   
• Interestingly, both the Fed and the markets still do not see eye to eye. However, they appear to be gradually converging. Consider these data points. On the one hand, the Federal Reserve has explicitly ruled out rate cuts in 2023. However, the market has sobered expectations and now expects just 25-50 bps rate cut in 2023.
   
• Finally, there appears to be a consensus emerging on the top. Markets and Fed minutes are pegging rates about 25 bps to 50 bps higher from these levels. A pause in June looks likely but rates could go down sharply in the next 12 months. Of course, signs of recession or a worsening banking crisis would hasten rate cuts. 

Essentially, the members want the Fed to retain optionality rather than getting married to a stance. The time for pragmatism may have finally arrived.

Growth, bank closures and debt ceiling

The relationship between interest rates and inflation has been well understood. Now members are focusing more on the likely trajectory of interest rates considering three key developments viz. GDP growth, bank closures and debt ceiling deal.

1. FOMC minutes show considerable debate over the series of bank closures in the recent past, including Silicon Valley Bank, Signature Bank and First Republic Bank. Clearly, the banking crisis had engendered further tightness as system liquidity and credit had become scarce. That was acting as a proxy to rate hikes. 
    
2. Members have repeatedly cautioned that if the debt ceiling was not raised on time, the resulting chaos could bring monetary policy into turmoil. A possible default by the US would send US bond yields soaring and that would make gradual inflation management redundant. Of course, that is a worst-case scenario, which nobody really cherishes.
    
3. On the one hand inflation is higher than expected and on the other hand labour data is strong with just 3.4% unemployment. But the bigger concern is over the GDP growth. Q1 GDP growth fell sharply to 1.1%, but Q2 is expected to bounce back to 2.9%. We have to await data as Fed minutes are talking about a likely recession in Q42023.

The gist of the Fed minutes is that the situation is very fluid and the Fed must keep a much optionality window available at this point of time. 

Do the Fed minutes impact Indian markets?

When it comes to the Indian effect, it is a kind of a Blow Hot / Blow Cold situation. The problem is that the minutes have indicated a high probability of a recession in the fourth quarter of 2023. A recession is not just about the crimping of oil demand. It is also about hitting tech spending as well as pressure on Indian exports. Remember, India runs the largest trade surplus today with the United States. Indian markets have already been hit by the debt ceiling.

However, there is a positive side to the minutes too. The big takeaway from the Fed minutes is that global hawkishness may be coming to an end after almost 15 months. If the Fed actually pauses in June 2023, it will be an affirmation that much of the pain is over. India has traditionally gained from global dovishness. It has helped economic growth; stock market returns and portfolio flows. That should be a big boost for the Indian markets too.

One concern for the RBI would be on the policy front. It is hard to recollect the last time the US offered high rates, weak growth, a possible recession, a banking crisis, and a potentially explosive debt ceiling. The question is; how will the RBI tweak Indian monetary policy in such a situation of heightened ambivalence. The real struggle will be about regulatory handling of the repercussions of US policy.

Content Source: US Federal Reserve