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Executive summary:

• Federal Reserve leaves rates unchanged at the June meeting but hints at the possibility of further tightening this year. 
• We think the Fed will do what it takes to combat inflation, but with interest rates already deeply into restrictive territory, the remaining upside to the path of interest rates will likely be limited. Further rate hikes also increase the risk that the Federal Reserve tightens too much. 
• Once a recession materializes, the Federal Reserve would likely be forced to aggressively cut interest rates, which would benefit holders of U.S. Treasuries. 

The bottom line: We continue to believe that U.S. Treasuries can have an important role to play in diversifying your portfolio

Are we there yet? The shrill voice of your kids shouting this question from the back seat of your car catches your attention. You look at your GPS, and say, 30 minutes to go. That calms them down, until 15 minutes later they start asking the same question. Ah, the joys of the summer road trip. But it could be more challenging.

The Fed’s long road trip sees a brief rest

The Federal Reserve Open Market Committee (FOMC) has been on a road trip of its own. In an effort to bring inflation back down to its 2% target, the FOMC has been raising rates at every meeting since March 2022, before finally deciding to leave rates unchanged at the June FOMC meeting. The decision to rest this month was broadly in line with what markets had been expecting immediately before the meeting. We think it’s understandable that the FOMC decided to leave interest rates unchanged today. With the FOMC having already been on a long road trip (rates have climbed by more than 500bps), it needs to take some time to assess how economic activity is responding to its decisions before proceeding further.

We might not be there yet – FOMC hints at further rate hikes to come

The June FOMC projection materials suggest that despite the long journey already traveled, it’s possible that we might not yet be at the peak federal funds rate. The median projection for the 2023 federal funds rate has moved up to 5.6%, compared to 5.1% in the March FOMC projection. That would suggest that we could potentially see two more rate hikes by the end of the year.

It's important to remember, though, that FOMC projections are merely forecasts, rather than a pre-commitment. Chair Jerome Powell himself underscored this point, indicating that the FOMC had only made a decision about this meeting, and that the July meeting would be “live”, meaning that while the Fed could resume hikes, they could also instead leave rates on hold for even longer.

Throughout the rate hiking cycle, the FOMC has emphasized that they would be data-dependent in their policy actions. Although lagging economic indicators such as overall employment in the U.S. have still been resilient, leading economic indicators have already begun pointing to signs of weakness that could lead to a recession sometime between now and 12-18 months from now. For a more detailed analysis of our economic views, refer to our May Economic Update and our upcoming 2023 Q3 Global Market Outlook (publishing on June 27).

We don’t doubt the Federal Reserve’s resolve to fighting inflation, but we would also underscore that economic conditions could change rapidly. If economic activity cools faster than expected, it is still possible that the Fed may not need to deliver more rate hikes at all. Conversely, if inflation remains stickier, the Fed might need to do even more than the two rate hikes telegraphed in the June FOMC projection materials.

Rain could mean a change of venue, and a recession could mean Fed rate cuts

As much as your kids might want to go to Disneyland, if it starts raining, you might be forced to go to the Getty Art Museum instead. The FOMC has tried to push back on both the notion of steep rate cuts and the notion of a potential recession. The June FOMC projection materials revised the 2023 real GDP (gross domestic product) growth to 1.0%, compared to 0.4% in the March projection. While the latest growth projection is still below the long-term trend, it’s more optimistic than what we would see in a recessionary environment. The FOMC also indicated that interest rates might stay elevated for some time, with the median FOMC participant expecting interest rates to remain above 3% at the end of 2025.

Despite the FOMC participants’ apparent optimism, we still see recession risk as being relatively elevated. In fact, even the Fed staff (who prepare their own forecasts independent of the FOMC participants) have conceded that a recession is a possible outcome.

If a recession materializes, the Fed would need to cut interest rates below the neutral rate of interest—the level of interest rate that neither stimulates nor restricts the economy—in order to provide sufficient economic support. With both the Fed and us estimating the neutral rate to be around 2.5%, this means that interest rates could fall significantly from their current levels, despite the projections in the June SEP (summary of economic projections) anticipating elevated rates through 2025. An economic storm can force the Fed to change the destination of its interest rate targets.

Why it’s important to buckle your seatbelts – What our cycle, valuation and sentiment (CVS) investing framework tells us about this road trip

Equity markets were a mixed bag in reaction to the Fed’s decision to skip a rate hike, with the Dow Jones Industrial Average down modestly, the S&P 500 Index around flat, and the NASDAQ up modestly as of the close on June 14, 2023. U.S. 10-year government bond yields were down slightly.

Given that economic headwinds still linger, equity valuations remain expensive, and equity sentiment is around neutral (but directionally shifting toward overbought), we think that it’s too early to celebrate. At the same time, there’s no need to get out of the car just because there might be some speed bumps or potholes ahead. We think that investors would benefit from buckling their economic seatbelts, and sticking close to their strategic asset allocations, while also considering including U.S. Treasuries as part of their diversified portfolio to help better weather a potential recession.

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