Will The Fed Cut Interest Rates In July?
The next step in Fed policy is a subject of intense debate among investors. Following what has already been a historic rate hiking cycle since last year in an effort to contain inflation, the good news is that indicators are moving in the right direction. The U.S. inflation rate for April at 4.9% is down significantly from its peak last June when it reached 9.1%.
Key consumer price categories across food, energy, and even transportation have slowed significantly over the last several months. Fed Chairman Jerome Powell has indicated the board believes the "disinflationary process has started" and opened the door for a "pause" in rate increases.
Softer trends in the labor market with rising initial jobless claims alongside weaker industrial production figures suggest a retreat from demand-side inflationary pressures. The understanding is that significantly higher rates are not necessary for inflation to continue normalizing lower toward the official target of 2%.
The market consensus right now is that the Fed will hold rates steady when it next meets on June 14th. Fast forward, the greater uncertainty is into the July meeting. According to the CME FedWatch Tool, fed fund futures pricing suggests a 23% chance of a rate cut to the Fed Funds Rate to 5.0%. We disagree with this scenario, making the case that the real odds for a cut are much lower, likely in the single digits.
In our view, the Fed is more likely to hold rates steady for several more months to make sure inflation is completely stamped out. The aspect of economic conditions being relatively "resilient" means that the Fed is not in a rush to cut. A dovish pivot with a Fed rate cut in July would likely project weakness in the economy which is unnecessary given the current data.
On the other hand, an extended pause by holding rates steady in July would project confidence that their strategy to control inflation is working. We suspect that a pause through at least September FOMC while inflation trends lower and economic activity outperforms expectation would be the best backdrop for risk assets eyeing a stronger recovery in 2024.
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