After the narrow stock market, the second major market development in Q2’23 was interest rates moving higher in a reversal of Q1’s decline. The markets continue to wrestle with the Fed’s “raise and hold” mantra, of not only raising rates to around 5%, but then holding them there for the rest of 2023. The back and forth is evident in the 2yr Treasury, the red line in the chart to the left, which made a steady march from 4% to 5% during February, as economic data and steady Fed messaging won over skeptical markets.
Chart 1
Of course, right as the markets bought into this narrative, the regional banking crisis reversed this move in merely a week in March, and the 2yr dropped back to the 4% range until mid-May. But from that point, the markets have once again been pricing in the Fed lifting rates to 5% and keeping them there, with the key development coming at a Fed policy meeting on 6/14, where rates were held flat at 5%. Heralded as “the pause”, it actually ended up being seen as “the skip”, as comments from Chairman Powell, paired with Fed members forecasting rates at 5.5% by the end of the year (meaning two more 25 bps rate hikes), suggested a shift to an every-other meeting pace, allowing more time for incoming data to be reviewed. Despite their best efforts to avoid a policy label, the every-other meeting cadence is called the “skip”. While the 2yr has retraced its 100 bps move to return to 5%, the 10yr has been a bit slower to move, and is yet to reach the 4% level it surpassed in both October ’22 and early March ’23.
Chart 2
Once again, markets are believing the Fed’s plans to “raise and hold” to slow the pace of inflation. Since the Fed’s first rate hike on 3/16/22, the Fed has pursued its fastest ever rate increase campaign (reflected in the surge in the 1yr Treasury from 0% to 5.19%) to combat the surge in inflation (Core CPI). Inflation has eased from its recent peak and, thanks to the rate hikes, the markets believe inflation will continue to fall, as reflected in the TIPS implied inflation rate of just 2.16%. The question is how much the economy will be impacted by this rapid shift. Ironically, it has been the recent strength in the economic data that has kept the Fed toeing its “raise and hold” line.
Entering Q3’23, the economy remains sound and the stock market has risen. Yet this optimism has caused interest rates to be high. This threatens both valuation (higher interest rates put downward pressure on PE ratios) and the fundamentals (higher rates slow economic growth). It is this paradoxical back and forth that has caused the interest rate ups and downs and will likely persist.
The Fed’s “Skip” Prompted Interest Rates to Jump in Q2. After impacting interest rates in Q2’23, the question is how much will the Fed’s move challenge the economy or equites in the second half of the year?
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