Why The Fed Has Just One Core Problem After The Rate Skip

Ahead of the Federal Open Market Committee meeting, markets swooned. When the Fed announced it would skip raising interest rates from the June meeting, the S&P 500 (SP500) closed exactly flat. Markets largely anticipated the central bank would break its consecutive strings of rate hikes. However, it did not expect plans for two more rate hikes sometime in the rest of 2023.

Core inflation is the root of the Fed’s problem. The downward direction since peaking late last year is favorable. The persistently high level is the core problem.

Fed Decision

The Fed voted unanimously to keep the interest rate paid on reserve balances at 5.15%, effective June 15, 2023. The Fed Funds rate will stay in the target range of 5.0% to 5.25%. In the question and answer session, Fed Chair Jerome Powell said the changed the rate of interest rate increases. This is the natural course for its data-driven policy in achieving price stability at maximum employment.

The Fed now has a terminal rate of 5.6%. The core price consumption expenditure remains persistently above target. It was 4.7% for much of this year, as shown below.

This is above the Fed’s 2.0% inflation target. Until this persistently high rate falls, the central bank needs to raise rates two more times this year.

The job market may withstand this hawkish policy. Unemployment rose to 3.7%, up from the prior 3.4%. It has room to let unemployment rise to 4.5% this year.

No Rate Cuts in 2023

Chair Powell said that the FOMC members were unanimous in refraining from cutting rates. Ongoing hopes of a Fed Pivot, or a rate hike, in 2023 are hopeful at best. Treasury yields were mixed. The 6-month (US6M) and 12-month (US12M) yields rose after the meeting.

The 30-year (US30Y) fell by 1.56% to adjust for expectations of another 50 bps increase this year. If markets expect rates rising no more than 50 bps in the rate hike cycle, it suggests that the 30-year ETF (TLT) will find support at around $102.00. Conservative income investors may wait for the momentum grade to improve from an “F” first.

Implications of a 5.6% Terminal Rate

Dividend income investors adjusted for the higher rate environment earlier this year. Widely held companies that paid dividends in the 3.0% yield range fell. For example, Johnson & Johnson (JNJ) is down in the year-to-date period.

Solid firms that paid yields lower than 2% fell by even more. Chubb (CB) lost 14.4% YTD despite strong factor grades in growth and profitability.

Income investors should not buy stocks solely only high yield. Chubb is increasing shareholder returns by buying back $5 billion worth of shares. Conversely, Verizon (VZ) has a dividend that yields 7.36%. Dividends from tobacco firm Altria Group (MO) yield 8.22% after trading ex-dividend on June 14.

Those firms have near-term headwinds from a slowing economy. Verizon risks reporting lower average revenue per user if customers downgrade their service plan. Smoking and vaping customers are unlikely to cut consumption of Altria products. Unfortunately, Altria shareholders need to ride out the Anheuser-Busch InBev (BUD) controversy. Altria owns a 9% stake in the firm. The advertising controversy caused customers to boycott its product.

Ignore Fiscal Policy

Reporters asked Chair Powell about the government’s trillions in spending policy, along with the accumulated debt. Powell said that fiscal policy is not the FOMC’s mandate. Its objectives are achieving maximum employment and price stability.

Investors should look at least three months’ worth of economic data and their trends. The core PCE must trend lower before the Fed considers cutting rates.

June 30, 2023, is the next PCE report. It will most certainly come in at above the Fed’s 2% target. Still, any drop would suggest that rates would start falling soon. At the very least, rates will fall starting in January 2024.

Is 2% Inflation Achievable?

Skeptics may scoff at the 2% inflation target. It will take the rest of this year and next year for that figure to fall to the 3.5% to 4.0% range. Investors should expect high interest rates are here to stay. Those who held money market funds missed out on stock gains this year. Nasdaq gained more than 33% from its lows and S&P 500 is up 14.3%.

Instead of chasing the market now, investors may continue to hold above-average levels of cash. Schwab Money fund (SNAXX) yields will rise from over 5%, as will the Vanguard money funds (VUSXX). The 0-3 Month Treasury Bond ETF (SGOV) yield is 3.57%. It will rise again after two more rate hikes.

Your Takeaway

The Fed did not satisfy bullish investors with future rate hikes. It did not cause a “sell on the news” after pausing the hike this time. It struck a good balance for growth and income investors. With a clear Fed policy ahead, investors may allocate their holdings spread among cash, dividend income, and growth.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.