Today will be the Fed's interest rate decision. A month ago ma | 💹 Review ELM EA [Results]

Today will be the Fed's interest rate decision. A month ago market expectations for the Fed decision at the May 3 meeting were 50/50 (leave it at 5% or raise it by 0.25 p.p.), now 90% in favor of a 0.25 p.p. rate hike.

If the March Fed meeting was in the midst of severe panic and uncertainty in the market related to the banking crisis. Now conditions have changed.

Once again, too strong macroeconomic data, high background inflation and a market that is trying to continue the "overhang" as company capitalization excluding the financial sector and the infotech is a negligible distance (a few percent) from the historical high set in January 2022. At the same time, the European market has already stormed through the highs.

The debt market has normalized and there is a very strong skew on the far end of the yield curve, where yields on bonds with maturities greater than 5 years have sagged in yields (increased in price).

This is due to both high demand for bonds after a record-breaking overflow of liquidity from deposits (most of it was concentrated precisely in bonds), and expectations of the Central Bank rate reduction soon (and quite intensive reduction).

As a result, for instance, 10-year bonds lost 0.6 p. p. of yield from 4-4.1% in early March to 3.4% at present. The yield curve has become highly inverted, with the difference between short-term and long-term bonds exceeding 1.6 p.p., the largest gap in the entire period of available statistics on treasuries.

The last time something similar (a 1.5 p.p. gap between 3-month notes and 10-year treasuries) was in the 80s, in 1989 the spread was 0.2 p.p., in the early noughties it was 0.9 p.p., and in Q1 2007 it was 0.5 p.p.

On the one hand, a decrease in the interest rates on bonds with the maturity of more than 3 to 5 years is positive, as it relieves the expenditures on interest payments on the debt.

On the other hand, previously in all cases the inversion of the yield curve (long-term bonds are lower than short-term bonds) coincided with the beginning of the economic crisis. The logic is understandable, since the inversion of the yield curve suggests market expectations for a lower rate, and this occurs when there are incipient imbalances in the system, both in the economy and in the financial market.

Going back to the Fed's decision following the May 3 meeting. The factors are forming in such a way that maneuvering space is greatly narrowed. Taking into account the abovementioned, we should add that the market expectations are unambiguously in favor of the rate increase, and the Fed has never "cheated" the market.

Although they tried to spin the banking crisis again a couple of days before the meeting, but it came out unconvincing. In the hierarchy of priorities, the inflation factor is dominating at the moment, so the Fed will have to raise the rates, even though the Fed was not going to raise the rates not only now, but also in March. Circumstances are such that they had to.

Inflation is too high and there is no room for the Fed to retreat, or else confidence will be undermined with far-reaching, devastating consequences.

This should be the last Fed rate hike, probably not just this year, but for many years. There is pain and disappointment ahead. The market is betting that the first, rate cut will not be until September 20 to 5%, then a 0.25 p.p. cut at each meeting and no more than 4.5% in December 2023 - the same amount that was in December 2022.

In March 2023, expectations for December were 5-5.75%, i.e., the banking crisis removed 1 p.p. But the market could be wrong this time too. Trigger should come sooner, which will require the Fed to act urgently as the banking crisis is always followed by a non-financial sector crisis with an increase in toxic debt (rising cost of debt service + crisis of confidence with inability to place) and a collapse in investment.

Due to inertia, a recession could come as early as July, but will there be a massive crisis?

Best Regards
Jared Winston
@develonbot