March FOMC Decision Preview

The Most Important Event of our Lifetimes is Back Again

Tomorrow's Federal Open Market Committee (FOMC) decision is expected to provide insights into the U.S. Federal Reserve's monetary policy stance, with several key factors shaping the discourse.

Among these are the timing and magnitude of potential interest rate cuts, the Fed’s balance sheet and potential tapering of QT and the countervailing inflationary pressures, the overall tightness of the labor market, and the relative resilience of the economy, particularly within the services industry.

We expect there to be no cut or change to quantitative tightening tomorrow, but we’re likely to get additional details about how policy could take shape from here. Including lots of banter about being “data-driven”, as this Fed is even more reactive than its predecessors, much to its own detriment (flashback to “inflation is transitory”).

Interest Rate Cuts: Market Expectations vs. Reality

Market expectations for interest rate cuts have been steadily declining over the course of 2024, starting with as many as six cuts and now down to just three being priced in according to Fed Funds Futures.

CME Group Fed Funds Futures suggest rate three cuts, after recently pricing out four

As we stated in our 2024 outlook, we believe 2-3 cuts are the most likely outcome for 2024, though in all likelihood any material loosening this year could prove to be a policy mistake for reasons we’ll soon discuss.

Timing of Interest Rate Cuts

The beginning of interest rate cuts is also subject that has been debated in the markets for much of this year. When 2024 began the presumption was a 25 bps cut for the March meeting, but as we can see below that and May have been completely priced out, with odds of a June cut reduced to just 63.21%.

We are of the view that July may be the first cut for the Fed, with the ECB starting in June. After all, Powell has said he wants to see at least six months of encouraging data on inflation. Providing him some cover to continue to defer the first cut into the second half of 2024.

This delay would provide policymakers with additional time to assess incoming economic data and determine the appropriate pace of monetary policy accommodation. A key facet of the “data-driven” approach that provides cover for the central bank to make decisions on the basis of backward looking trends in the economy.

Inflationary Pressures and a Resilient Economy

Several factors suggest that the FOMC will proceed cautiously when it comes to easing monetary policy. These include resurgent inflationary pressures, wages rising faster than desired, and a resilient economy. Despite recent declines in headline inflation, core inflation remains stubbornly high, putting pressure on the Fed to maintain its restrictive policy stance for longer than initially anticipated.

US CPI monthly readings are accelerating

We’ve also seen powerful wealth effects in stocks, real estate, crypto and other assets which have helped to buoy demand and certainly could give the Fed pause about the urgency of any cuts in the near-term. Cutting into such an environment could encourage speculation to run into a mania, much like we saw in the late 1990s. We’re not quite there yet, but we’re certainly in euphoric territory per sentiment, flows and positioning all being quite stretched.

Therefore, we do hold the view that cutting in 2024 without a greater economic slowdown and some reprieve from rising asset prices could prove later to be a policy mistake as it may further spurn inflation due to the demand increase that such policy decisions could encourage.

The Dual Mandate and Its Implications

The Federal Reserve's dual mandate of maintaining stable prices and maximum employment also plays a role in determining the pace and timing of interest rate cuts. With inflation still above target and the labor market remaining strong, there is arguably less urgency to ease monetary policy at this juncture.

This, too, could result in a more measured approach from the FOMC, with policymakers waiting for clearer signs that inflation has returned to its 2% target before reducing interest rates. After all, there’s no reason to fix what isn’t broken.

While some have cited CRE as a concern for policymakers, if we saw anything in 2023, it was that the Fed, Treasury, and FDIC can foam the runway by using specialized facilities like the bank term funding program (BTFP) without changing their entire policy framework. Meaning there’s no real urgency to cut the Fed’s interest rate simply due to office building debts becoming problematic for some regional banks with too much exposure.

The Balance Sheet and Quantitative Tightening (QT)

Tomorrow's meeting will also likely touch on the topic of the Fed's balance sheet and the timing of quantitative tightening tapering to a lower run rate. While specific details are not expected to be provided, it is reasonable to assume that policymakers will discuss the potential for slowing or stopping QT in the coming months.

The Fed’s balance sheet, shrinking but still quite large

Some Fed speakers have cited bank reserves and the balance in the overnight reverse repo market has benchmarks for where they may begin to slow the rate of quantitative tightening. We’ve also heard about variations of Operation Twist, a prior Fed program where maturities of holdings were rebalanced, with one Fed speaker suggesting that the Fed attempts to sell MBS to buy bills and Powell himself suggesting shortening the overall duration exposure of the Fed’s balance sheet.

Summary of Economic Projections (SEP) Report

The FOMC decision will also include an update on the Fed's projections for the economy, inflation, and its policy rate in the form of the Summary of Economic Projections (SEP) report. The SEP is expected to provide insights into the Fed's views on the outlook for economic growth, unemployment, and inflation, as well as the potential trajectory of interest rates in the coming years or what’s called the “Dot Plot”.

We believe that the Fed is likely to continue to signal three cuts in 2024 in the Dot Plot as market expectations have been shifting to be more inline with the Fed’s own estimates after recent upside surprises in economic and inflationary data.

Closing Thoughts

With the market largely pricing in what we expect from the Fed, the biggest catalysts for upside or downside in rates and risk would be dovish or hawkish deviations from the consensus view.

If Powell, for example, were to come out and say that recent inflationary data has the Fed concerned about cutting too early and the Dot Plot showed two instead of three cuts, we could see a big push higher in rates on the short-end and equities roll over.

On the other hand, if we see the Fed Chairman signal that the battle against inflation is rocky but they are confident that we’ll get back to 2% and they’re willing to cut earlier without seeing it trend in that direction decisively, and we see the Dot Plot show four cuts being planned, that could cause rates to drop and equities to rally to new all-time highs this week.

Going into tomorrow this is not a very well-hedged market, with lopsided long exposure in equities and particularly within concentrated trades like mega cap tech and growth.

While there were some hedges put on today, they pale in comparison to the magnitude of long exposure. Meaning the bigger risk is for downside if the Fed comes out more hawkish than expected than upside of the Fed comes out more dovish than expected in our view.

As always, we find it’s best to let the dust settle after the event before making any investment decisions, which often takes about 2-3 trading days.

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