Fed Doesn’t Flinch…Yet

The Federal Reserve’s March 22 meeting was the first since turmoil struck the banking industry. Two weeks ago, regulators closed Silicon Valley Bank and Signature Bank and made the controversial decision to bail out uninsured depositors to prevent further bank runs. Investors wondered if worries about financial instability would cause the Fed to flinch. Would it pause its rate-hiking campaign? Or would it continue the fight against inflation by raising rates again?

In the end, the Fed didn’t flinch but gave indications its resolve may be wavering.

Rising interest rates

At Wednesday’s meeting, every voting member of the Federal Open Market Committee agreed to hike the Fed Funds rate another quarter-percentage point to a range of 4.75%-5.00%. But Fed Chair Jerome Powell said the committee considered pausing in light of the stress in banks and the possibility financial institutions will pull back on lending, further tightening financial conditions.

The Fed’s post meeting statement said, “Some additional policy firming may be appropriate.” Market watchers took this as a substantial downshift from previous language promising “ongoing increases.” At the very least, the Fed’s latest language provides room for future policy flexibility as a year of tighter monetary policy has, on a lagged basis, led to cracks in credit and the economy at large. This openness to change led some to label the Fed’s Wednesday move a “dovish hike.”

The Fed Funds rate is now only about a quarter percent below the Fed’s own projections for the rate’s level at the end of 2023, further suggesting that we are reaching the end of this hiking cycle. Market participants are in fact betting on a substantial easing in policy over the rest of the year, with futures markets predicting three rate cuts and a sub-4% Fed Funds rate by year end.

Fixed income’s role for investors

If we extend our view from short-term rates and look at the full yield curve in Figure 1, we can see increasing conviction by investors that the Fed’s actions are putting downward pressure on inflation … but also economic growth. Two-year Treasury yields have declined over a percentage point from March 8—a huge decline for this market in so short a period—while 10-year Treasury yields are down over half a percent.

Treasury yields near their 2023-to-date lows mean investors in high-quality bonds have seen price appreciation in 2023. Just as important, they have seen their bond portfolios return to their role as a source of stability during bouts of equity volatility.

We believe markets are approaching the peak in short-term interest rates and that the steeply inverted yield curve (with short rates much higher than long rates) is likely to flatten over the course of the year. We continue to recommend that investors match their bond strategy to their investment horizon rather than concentrating portfolios in one part of the yield curve. Total return, not income alone, is the name of the game in fixed income.

Finally, we believe that the Fed’s actions to address the cracks in the banking system will prove successful, but we remain patient when assessing the credit landscape as recession risks remain. Our bond separately managed account portfolios have no exposure to troubled banks that have been in the news, and our mutual fund model portfolios have navigated this most recent crisis well, without material exposure to the most vulnerable credits.

Diversified bond portfolios remain attractive at today’s yield levels, and we believe our portfolios are poised to capitalize if and when market volatility does indeed cause the Fed to flinch and pause or pivot to rate cuts.