The market meets (the Fed’s) expectations

Such a sudden shift in short-term rates, combined with the uncertainty around the debt ceiling that prevailed in the last two weeks, could have been disruptive. However, thankfully, this latest bout of volatility has been orderly and has not caused any noticeable market dysfunction – albeit liquidity has not fully recovered to pre-SVB levels.

A fundamental shift

Following the Global Financial Crisis of 2008, whenever there was a divergence between the Fed’s projections and market participants’ expectations, more often than not it was the Fed that ended up meeting market expectations. In other words, markets were conditioned to being able to “force” the Fed – or at least believing they could do so. When the Fed tried to be less dovish, markets pushed for more cuts or more quantitative easing and the Fed duly obliged. Similarly, when the Fed tried to signal the end of the easy money cycle, the market threw a “tantrum” which led to the Fed adjusting its interest rate trajectory.

As such, the fact that markets have converged towards the Fed’s expectations is very salient and could have some interesting consequences.

1. The Fed credibility is (slowly) being restored

The Fed previously lost some of its credibility due to its insistence on depicting inflation as transitory, and its belated action in reining it in, which could lead to potentially higher costs to the economy (some of which are yet to be witnessed).

The combination of the Fed proceeding with a rate hike in March despite the turmoil caused by the flight of deposits from some regional banks, and their steadfastness in keeping with the higher for longer message, seems to have finally impacted the market’s appreciation of the Fed and re-established its credibility in part.

This is a very positive development for the Fed and markets, because trust in the Fed’s ability to deliver what it promises is a key tenant of a sound market and brings the level of uncertainty (i.e. potential volatility) generally lower. Going forward, even in tense settings, we can expect the market to face volatility with more serenity and calm.

2. Inflation control prospects have solidified

As it stands, the market has resigned itself to seeing higher (rates) for longer, with no rate cuts on the horizon until closer to the end of 2023. Once again, this is a positive development to the extent that it will likely help anchor long-term inflation expectations while providing the Fed with time to assess whether inflation stickiness dissipates in the near-term.

However, this higher for longer strategy comes at a cost, that of a potential recession and economic slowdown. The health of households’ balance sheets at the start of this hiking cycle and the strength of the labor market so far have helped sustain economic growth. Yet, weaknesses have started appearing in different corners of the economy and investment landscape. For instance, the higher cost of capital has adversely affected the growth of investments in private assets and borrowing for mid-tier corporations. Real estate valuations also remain an area of focus and should be monitored.

Another corollary effect of the recent run up in short-term US yields has been a slight appreciation of the US dollar and a drop in commodity prices. At this juncture, we see the fast-paced repricing of the front of the curve nearly complete and, as a result, rate markets and the US dollar will likely be more stable through the summer as we await more data on the inflation front.