July Fed Meeting Preview: Markets Expect Another Big Rate Hike
Markets expect the Federal Open Market Committee (FOMC) to deliver another aggressive rate hike at its upcoming meeting on July 26-27. The Federal Reserve‘s 75 bps rate hike in June to 1.5% to 1.75% was its largest since 1994.
The FOMC will likely make its second consecutive 75 basis point (bps) rate increase and continue to allow assets to roll off its nearly $9 trillion balance sheet as it attempts to lower inflation without sending the U.S. economy into a recession.
The S&P 500 is down more than 20% year to date, thanks to growing concerns that the Fed will not achieve a “soft landing” for the economy.
On July 5, the yield on 2-year U.S. Treasury notes jumped above the yields on 10-year Treasury notes, a phenomenon known as a yield curve inversion. More than two-thirds of past yield curve inversions have been followed by U.S. recessions within the following year.
Another 75 bps Rate Hike Is Expected in July
The bond market is currently pricing about a 90% chance of another 75 bps rate hike at the July Fed meeting. According to the CME Group, there’s roughly a 9% chance of a 100 bps rate hike.
A second consecutive 75 bps Fed interest rate increase would increase the federal funds rate range to between 2.25% and 2.5%.
The bond market is pricing in an 83.4% chance the target rate range will climb to between 3.25% and 3.5% or higher by the end of 2022.
The FOMC is also expected to continue its plan to allow up to $30 billion in Treasury securities and $17.5 billion in agency mortgage-backed securities (MBS) to mature and roll off its monthly balance sheet.
Starting in September, the Fed plans to ramp its monthly roll-off to $60 billion in Treasurys and $35 billion in MBS per month.
In June, the Fed updated its long-term U.S. economic projections to reflect its less rosy outlook for GDP growth and inflation. The Fed cut its 2022 GDP growth estimate from 2.8% to 1.7% and its 2023 GDP growth estimate from 2.2% to 1.7%.
The Fed also raised its 2022 growth forecast for the Personal Consumption Expenditures (PCE) price index, a popular measure of inflation. Fed economists expect the PCE index to rise 5.2% in 2022 but only 2.6% in 2023 as inflation subsides.
Five out of 18 FOMC participants project the federal funds target interest rate will exceed 4% in 2023.
U.S. Economy Holding Steady So Far
The inverted yield curve and a recent downturn in consumer sentiment are warning signs for economists that inflation and rising interest rates could weaken the U.S. economy.
Fortunately, the latest employment numbers suggest that weakness hasn’t yet hit the labor market.
On July 8, the U.S. Labor Department reported the economy added 372,000 jobs in June, exceeding economists’ estimates for 250,000 jobs added. The U.S. unemployment rate held steady at 3.6%, while the labor participation rate ticked down by 10 basis points to 62.2%. Average U.S. hourly earnings were up 5.1% from a year ago and up 0.3% compared with May.
Quincy Krosby, chief equity strategist for LPL Financial, says weakness in the S&P 500 immediately following the monthly jobs report reflects market fears that a strong labor market gives the FOMC the green light to take aggressive measures in July.
“The immediate market reaction was negative based on concerns that the Fed’s aggressive campaign to curtail inflation will continue even with wage growth stabilizing,” Krosby says.
“The market has moved into the good news is bad news phase, as it had hoped that a weaker headline payroll report would signal that the Fed-induced economic slowdown would reduce payrolls and allow the Fed to check off another box,” he says.
In addition to a steady labor market, Wall Street analysts still expect solid S&P 500 growth numbers as the second-quarter earnings season kicks off this month. Analysts are projecting 4.3% S&P 500 earnings growth and nearly 10.2% revenue growth in the second quarter compared with a year ago.
Inflation Remains Stubbornly High
Unfortunately, the Fed still has a long way to go to bring inflation levels back to its long-term target of 2%.
In late June, the Commerce Department reported the core PCE price index, the Fed’s preferred inflation gauge, was up 4.7% in May, a slight reduction from the 4.9% gain reported in April. The core PCE inflation number excludes volatile energy and food prices.
Bill Adams, chief economist for Comerica Bank, says inflation is weighing on U.S. consumer sentiment, which could ultimately impact consumer spending and corporate earnings growth.
“The rising cost of living absorbed all of the increased spending power from added jobs and higher wages in May,” Adams says.
“Most measures of inflation have likely peaked, although tight inventories of oil, gas, and diesel mean risks to energy prices are still to the upside.”
Chatty Fed Officials Talk Rate Hikes
In the weeks since the last FOMC meeting, several Fed members have provided hints for investors about what they can expect from the July meeting.
The FOMC released its June meeting minutes on July 6, and the language in the report strongly implies another 75 bps hike is coming in July.
In the release, the FOMC warned that its aggressive monetary policy adjustments could “slow the pace of economic growth for a time” but noted that inflation “could become entrenched” if the American public loses confidence in the Fed’s ability to rein it in.
On July 7, Fed Governor Christopher Waller said he is “definitely in support of doing another 75 basis point hike in July.”
The same day, St. Louis Fed President James Bullard said it would “make a lot of sense to go with the 75 [bps hike] at this juncture.”
In the press conference following the FOMC’s June meeting, Fed Chair Jerome Powell said “either a 50 basis point or a 75 basis point increase seems most likely” for the Fed at the July meeting.
Could a 75 BPS Hike Be a Bridge Too Far?
Brian Price, head of investment management for Commonwealth Financial Network, says anything other than a 75 bps rate hike in July would surprise the market.
“At this point, I think the market is expecting the Fed to hike 75 basis points at the July meeting,” Price says.
“Economic data has been rolling over a bit as of late, but I think the labor market is still running hot and we haven’t seen any meaningful adjustment downward in the prices that consumers are paying for food and gas.”
Between now and the beginning of the FOMC meeting on July 26, the Fed will get a couple of more important data points on the health of the U.S. economy. The Labor Department reports its June Consumer Price Index (CPI) inflation reading on July 13 and the Census Bureau releases its June Retail Sales report on July 15.
In addition, FOMC members will likely be closely watching the first wave of second-quarter earnings reports in the coming weeks, particularly reports from major U.S. banks. A significant drop in loan growth or overly negative commentary from bank management could be a warning sign that the economy is rolling over.
