The US central bank may have indicated a pause on its 14-month rate hike cycle but market participants are divided as to whether it will cut rates as economic growth slows, credit conditions tighten and a banking crisis unfolds.
In a widely expected move, the Federal Reserve this week raised its benchmark overnight rate by 25 basis points to a range between 5% and 5.25%, the tenth consecutive increase since March 2022. But in a signal that it’s hitting pause, the Fed’s rate statement omitted a previous reference to additional increases being needed.
“People did talk about pausing, but not so much at this meeting. There’s a sense that we’re much closer to the end of this than to the beginning,” Fed Chairman Jerome Powell said at a press conference. “If you add up all the tightening that’s going on through various channels, we feel like we’re getting close or maybe even there, but again that is going to be an ongoing assessment.”
Ray Sharma-Ong, investment director of multi-asset investment solutions at UK asset manager abrdn, points out that the policy rate is now in line with the implied terminal rate in the Fed’s latest economic projections released six weeks ago.
“With real rates above neutral rate, the Fed cautious on impact to the banking system, credit tightening, and quantitative tightening in place, this raises the hurdle on how strong US economic data needs to be for the Fed to hike in June 2023,” Sharma-Ong writes in a report on May 4.
The collapse of three regional lenders has also sparked worry about a banking crisis, though Powell said that the banking sector “is sound and resilient, and conditions have improved since the last meeting”.
Sharma-Ong believes tighter credit conditions will drive the US economy into a recession in the second half of this year.
“We expect the Fed to cut rates when a recession occurs,” he says.
But Tai Hui, Asia Pacific chief market strategist at J.P. Morgan Asset Management, argues that the prospects of rate cuts are unclear.
“During the press conference, Powell pushed back against the potential for rate cuts later this year given the committee expects inflation will move down at a slower pace than what markets anticipate, unless there is a material deterioration in the US economy,” he says in a report. “Hence, a slowdown, or even a mild recession, may not be sufficient to convince the Fed to reverse policy course soon.”
Meanwhile, the US asset management firm continues to prefer bonds over equities, especially high-quality debt such as developed market government notes and investment grade corporate bonds. But it favours Asian stocks over developed market equities.
“Despite a relative underperformance year-to-date, we prefer China and Asian equities over developed market equities given the contrast in growth momentum and policy backdrop,” Hui writes.