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Hint of A Pause

During April, the North American Capital markets traded back and forth between investor optimism and concerns. With one eye on the US Federal Open Market Committee (FOMC) decision after their meeting on May 3, the developments during the month and their read through on the potential future trajectory of policy rates dictated the price action. A decline in headline inflation from +6.0% in February (reported in March) to +5.0% in March (reported in April) in the US and from +5.2% in February (reported in March) to +4.3% in March (reported in April) in Canada helped investor sentiment. The markets later pulled back with more regional bank failures in the US increasing investor concerns of a potential contagion, only to be helped again by the better-than expected reported earnings by a few mega-caps in the index. Overall, the price action during the last week of the month helped equity markets end in green.

On May 3rd, the US Federal Reserve Chair, Jerome Powell, announced a 25 basis-points policy rate hike, in line with market expectations but stopped short of explicitly announcing a pause to the policy rates hikes. Nevertheless, the use of language such as “close to a pause or maybe even there” and “possibly at sufficiently restrictive levels” led industry participants to believe that a pause might be announced as soon as the next meeting in June. While this was in line with the market expectations, we think equity markets reacted poorly as on the balance the message was perceived as hawkish. The US Federal Reserve Chairman re-emphasized that the committee is sticking to the goal of bringing inflation back to 2% and rebutted any expectations of a rate cut during the year. The message is at odds with fixed-income market expectations that are baking in ~59.8% probability (as on May 4th) of an interest rate cut as soon as during July meeting (Source: CME Group).

The news flow of regional banks failures in the US has continued unabated and added to investor angst over the past few weeks. The Fed chair stated that the overall financial system is sound and the recent regional bank problems are supportive of the Fed’s objective of bringing down inflation by further tightening financial conditions. In other words, the central bank is prepared to let markets endure some pain while it awaits inflation to get close to the 2% goal before it even considers a rate cut. Reduction in availability of credit, leads to destruction of demand and thus helps bring back the demand-supply imbalance. The risk in this approach is that the tightening could worsen to the level of a credit crunch which would lead to a severe recession. Thus far, markets have traded consistent with the expectations of a mild recession or a soft landing.

The Fed chair further pointed out that inflation as measured by the ‘core services ex-housing’ is still too high and the committee would like to see it receding before even considering a rate cut. The bad news is that the measure typically declines during a recession (See Figure 1) and the good news is that with interest rates now at 5.25%, the Fed has ammunition to help the economy should a recession ensue in the quest to bring this inflation measure down.

Figure 1: Inflation typically declines during a recession

Graph of US recession vs. US Bloomberg PCE Core vs. Federal Funds Target Rate
Source: Bloomberg

Overall, we think the reduction of the gap between market expectations and the Fed’s guidance is fraught with more bank failures and crisis scares in the short-term. While peak policy rates do make a case for adding some risk to the portfolios, an overall defensive position makes sense to navigate through the near-term volatility at this stage of the cycle, in our view.

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