Investment managers react after the US Federal Open Market Committee voted this week to keep interest rates unchanged in a 5.25 to 5.5 per cent target range, in line with expectations.

Markets gave a mixed reaction on Wednesday - bond prices rose and equities eased after initially rising - after the US Federal Open Market Committee (FOMC) kept interest rates unchanged. UBS Global Wealth Management and a number of other wealth managers commented on what they think the central bank is likely to do for the rest of this year.

This decision marks the sixth consecutive time the Fed paused since starting its 525 basis point hike-cycle in March 2022. The committee also announced a slower pace of quantitative tightening (QT) with a new monthly cap on the US Treasury securities of $25 billion starting June.

But while Fed Chair Jerome Powell noted the uncertain path forward for US inflation, UBS Global Wealth Management said its base case remains that inflation and economic growth will cool off, allowing the Fed to begin cutting rates in September. As a result, the wealth manager recommends having quality bonds and quality stocks.

Markets appeared to digest the idea that the Fed is taking a cautious approach, with rate rises only likely towards the fall. US equities initially rallied and 10-year Treasury yields fell 10 basis points after Powell said that it was unlikely the next move in rates will be a rise. Equity sentiment did not last, however, and the S&P 500 closed 0.3 per cent lower Wednesday, while the 10-year US Treasury yield declined by five basis points to 4.63 per cent.

Exceeding expectations
Zurich-listed UBS also highlighted that inflation has exceeded the committee's projections for the year as it nears the long-term goal of 2 per cent. Since incoming data has still not provided the committee with enough evidence and confidence that its current policy rate is sufficiently restrictive for inflation to return to 2 per cent over time, Powell spoke of the need for additional time before the committee cuts rates while also seemingly ruling out another hike.

Fed officials had started sounding more hawkish prior to the blackout period, consistently saying that rate cuts are unlikely anytime soon. After Wednesday's US equity close, Fed funds futures markets adjusted their 2024 rate-cut expectations to 34 basis points, with the first rate reduction priced to start in September.

“We maintain our base case for two 25 bps Fed rate cuts in 2024, likely starting in September. In our view, current economic conditions are consistent with a soft landing this year, even if this outcome isn’t without an occasional speed bump, as has occurred in April,” Mark Haefele, chief investment officer at UBS Global Wealth Management, said in a note.

As this outcome becomes more apparent in the data, he expects fixed income markets will recover and forecasts 10-year US Treasury yields to decline to 3.85 per cent by year-end compared with 4.63 per cent currently. He also expects further modest gains for equities at the index level. 

UBS said a higher-for-longer rate environment in the US does translate into a similar policy lag in Asia, but the region’s recovery in exports, industrial activity, and real economic growth continues. UBS thinks the recent market consolidation presents dip-buying opportunities in leading AI beneficiaries, large-cap Indonesian and Japanese banks, as well as Chinese SOEs. “While volatility will likely persist in the short term as markets swing between different risk scenarios, specific opportunities to buy on dips remain. We also believe that portfolios that are well diversified across geographies and asset classes are better positioned to weather a changing macro environment," Haefele said.

Janus Henderson
Meanwhile, the Janus Henderson fixed income teams believe that policy is doing its job albeit slower than the progress witnessed in the back half of 2023. The normalization process back to their 2 per cent goal will clearly take longer than many anticipated but they think patience is the right approach. They are seeing signs of slowing economic growth which may be indicating the Fed’s cuts are slowly working their way through the economy and could potentially impact US macro data negatively in the nearer term. At Janus Henderson, they believe whether this is higher for longer or higher for now, investors should continue to take advantage of these decade-high yields.

Brandywine Global
Jack McIntyre, portfolio manager, Brandywine Global, also highlighted that there was a sigh of relief in the financial markets after the Fed refrained from increasing its hawkishness at the May FOMC meeting. Powell said rates are currently restrictive enough, meaning a rate hike is highly unlikely. But he also cautioned that inflation is still too high to start cutting rates too soon. Think of this outlook as "high for longer" as opposed to "higher for longer." “The latter implies rate hikes, which is not today's story. The Fed is not expecting growth to accelerate, which again means monetary policy currently is well positioned,” McIntyre said.

“The only surprise came on the quantitative tightening side of policy by cutting the pace of reduction in US Treasuries. This adjustment doesn't mean QT is ending anytime soon, only that a smoother ride is likely,” he added. “The next big Fed event comes at the June FOMC. It will be important to see the projections for the longer-term equilibrium Fed funds rate, since it has implications for where the 10-year Treasury rate ends up. Helping the bulls was today's sharp move lower in oil prices, which is good for noninflationary growth.”

ClearBridge Investments
Josh Jamner, investment strategy analyst at ClearBridge Investments, meanwhile emphasized that the Fed was “prepared” to cut rates “if the labor market weakens,” while hinting repeatedly at a higher bar for a rate hike and that it was “unlikely the next move is a hike” while reiterating the view that monetary policy is sufficiently restrictive to bring inflation back to the 2 per cent target over time.

“This leaves the Fed in 'wait and see' mode after inflation has come in higher than they expected so far in 2024, meaning it will take “longer than previously expected to gain confidence” that inflation is on track to return to 2 per cent, which has been the barometer Powell outlined the committee is looking for in order to cut rates … simply put, higher for longer is alive and well,” Jamner said.

Quintet Private Bank
“The surprising thing about the Fed meeting is the announcement of a slower balance sheet run-off. What this means, in practice, is that the Fed will now absorb a greater bond supply than previously,” Daniele Antonucci, chief investment officer at Quintet Private Bank (parent of Brown Shipley), added. 

“This means that the private sector won't be required to buy US Treasuries to the same extent as before, possibly freeing up the balance sheet to reallocate to riskier markets such as equities and credit. Unsurprisingly, the Fed is acknowledging that the series of upside inflation surprises we’ve seen over the past few months does amount to no further progress to get to the 2 per cent target,” Antonucci continued.

“This means that the central bank is indeed delaying the start of the rate-cutting cycle. Rather, it's now likely to maintain borrowing costs at an elevated level for longer. Markets now only expect the first rate reduction at year-end, with some probability that the next move, rather than a cut, could be a hike,” he added.

While Antonucci thinks that cutting rates somewhat later is warranted, he doesn’t believe the Fed is signaling that conditions would warrant further policy tightening. “In all, markets seem to be well aware of the risks to the Fed rate outlook. More uncertain appears the picture for the European Central Bank and the Bank of England. Economic conditions are weaker in the eurozone and the UK vs the US, and inflation trends are more subdued. This would warrant rate cuts, and sooner rather than later, but the issue is the currency,” Antonucci said.

“If the European Central Bank (ECB) and Bank of England (BoE) were to cut aggressively while the Fed decided to stay put, the euro and pound sterling could weaken, driven by the interest rate differential between US and European rates,” he added. “In turn, a weaker currency would raise import prices, driving inflation higher. This is why Fed policy, via the currency channel, could have quite an impact on monetary policy on this side of the Atlantic.”