Falling in line
The markets have finally listened to hawkish Fed speak.
The Federal Reserve touts its diverse set of tools for crafting monetary policy, but since March 2022 it has mostly used the hammer. After 10 straight swings at the economy in the form of rate hikes, in June it dropped it back into the toolbox by not raising the fed funds target range. Instead, the Fed updated its blueprint for the tightening cycle, the Summary of Economic Projections (SEP), to suggest more hikes to come.
This was a shrewd move. Policymakers not only bought time to assess the economic impact of those 500 basis points of hikes and the effect of the debt ceiling debacle, but also they reset market expectations. The latter is crucial. Even though the Fed hiked in March and continued to talk tough about inflation, investors didn’t buy it. In April and May, they forecast rate cuts in the second half of this year. It didn’t make much sense to us, but it distorted the shape of the Treasury yield curve. Longer-dated government securities weren’t paying enough, compelling cash managers to stay short.
In the new SEP “dot plot,” Fed policymakers forecast the median fed funds rate to climb to 5.6% by year-end. That would require at least two more 25 basis-point hikes—an expectation shared by 12 of 18 voters—with one likely to come at July’s meeting. The markets finally relented. The short end of the curve is returning to normality, with 6-month Treasuries yielding more than 1- or 3-month. Contributing to the normalization is the Treasury Department’s flood of issuance to refill its tank after running on fumes. And lest you think the dive that the headline Personal Consumption Expenditures Index (PCE) took in May (plunging from 4.3% in April to 3.8%) will persuade policymakers to cut, core PCE (which strips out volatile energy and food prices and has more credence with the Fed) barely budged, just slipping from 4.7% to 4.6%.
Another sign of financial health comes with the decreased use of the Fed’s Reverse Repo Facility (RRP). The $2.3 trillion level it reached in spring is now looking like a peak, as participants tapped it for under $2 trillion in late June. Traditional counterparties—firms that create reverse repo markets—are stepping up to the plate with rates above the RRP.
The broad market of non-Treasury/agency instruments, such as commercial and bank paper, largely brushed off the potential for government default, and yields have been strong. This is one reason retail—that is, non-institutional—clients have been pouring assets into prime money market funds and similar liquidity products industry wide, even as assets under management in government funds have decreased slightly. The environment has us slightly increasing Weighted Average Maturities franchise-wide, but we have not raised our target ranges from 25-35 days.
Libor no more
The biggest news of all this month could be that the dollar-dominated London interbank offered rate (LIBOR) officially ended and no one cared. As of June 30, the Intercontinental Exchange Benchmark Administration will no longer publish it. This benchmark was a stalwart of setting short-term interest rates between major global banks for decades, until it was revealed it had been manipulated during the Global Financial Crisis. In the U.S., the approved benchmark rate is the Secured Overnight Financing Rate (SOFR). The change has been three years coming, so anyone who missed it had to be clueless.