As the Fed Pauses, a Moment to Speak to Poor Yorick

Avoiding an economic tragedy worthy of Shakespeare.

Even with interest rate hikes, Shakespeare always seems to have a quote that captures the moment. 

“To be, or not to be, that is the question” is of course from Hamlet, when the Prince of Denmark chats with the skull that once belonged to Yorick. In his soliloquy, Hamlet contemplates death and suicide, weighing the pain and unfairness of life against the alternative, which could be worse.  

To pause or not to pause is the question facing Chairman Powell and his colleagues at the Federal Open Markets Committee next month.  

The U.S. Federal Reserve yesterday paused interest rate hikes after 10 consecutive increases. When it announces its next monetary policy move in mid-July, it may not be a life-or-death decision. Still, the decision to raise, cut or hold might ignite turmoil in markets across all asset classes. After Wednesday’s pause, investors expect a boost next month. 

The Vanguard Short-Term Treasury Index Fund (VGSH) could experience volatility as the next Fed meeting approaches and after the central bank decides if a pause is appropriate. 

Reasons to Pause 

The Fed’s 2023 target has been 5.125%, and the central bank reached that goal in early May 2023. Aside from reaching its target, the following factors favor a credit-tightening pause over the coming months: 

• Recent consumer and producer price index data has shown that inflation is declining from 2022 levels, reducing pressure to increase short-term interest rates.  
• Bank failures have raised worries that continuing credit tightening will negatively impact the banking sector and spark a recession. Banks have tightened credit, doing the central bank’s job without additional Fed hikes.  
• Stock market price action, recent employment data and other factors indicate an economic equilibrium, which the Fed is charged with achieving. 
• The Fed was criticized for waiting too long to raise rates, and will likely avoid going too far with tightening credit and causing a recession. 
• A pause will allow the recent rate hikes to filter through the economy. 
• Quantitative tightening, reducing the Fed’s balance sheet, is another form of tightening credit that continues. 

The U.S. central bank has increased short-term interest rates to a level where the consensus for the next FOMC meeting does not overwhelmingly support another interest rate hike.  

Reasons Not to Pause 

The hawks at the Fed could decide that another 25 basis point fed funds rate increase is appropriate for the following reasons: 

• Inflation remains above the central bank’s 2% target rate and the fed funds rate in early June 2023. 
• The latest employment report that indicated 399,000 new jobs, above the market’s expectations, was a sign of continued strength that could cause the central bank to continue tightening credit. 
• The hawkish committee members have not ruled out further rate hikes that will be data dependent.  

Alan Greenspan once said that the Fed’s best position is when the market can’t predict its actions at an upcoming FOMC meeting. The central bank may be in former Chairman Greenspan’s optimal position.  

Impact on VGSH 

VGSH tracks a market-value-weighted U.S. Treasury-issued fixed income securities index with one- to three-year maturities. The Fed’s pause may lift VGSH, while another rate hike could do the opposite.  

At $57.79 per share, and with $22.4 billion in assets under management, VGSH trades an average of over 3 million shares daily and charges a minimal 0.04% management fee. 

The fund flow tool on etf.com highlights that funds have flowed into VGSH in 2023 as investors and traders take advantage of the highest interest rates in years.  

The chart highlights that over $4 billion has flowed into VGSH since the end of 2022.  

Unintended Consequences 

In 2021, the U.S. central bank blamed rising inflation on “transitory” pandemic-inspired supply chain issues. The economic condition rose to the highest level in over four decades, igniting criticism.  

The Fed’s March 2022 pivot led to aggressive interest rate hikes that raised the short-term fed funds rate by 500 basis points, and quantitative tightening pushed rates higher further along the yield curve.  

With the fed funds rate at 5.125% and longer-term rates considerably higher, the Fed must choose its next path in July. Continued hikes will have unintended consequences, as the market learned from U.S. and European bank failures.  

I had predicted yesterday’s pause, which could cause bonds and VGSH to rise from the current levels as the pressure on bonds abates. The pause was the least controversial path, allowing the central bank to monitor economic data and watch the past tightening to work on inflationary pressures.  

The chart highlights the sideways-to-a-slightly bullish pattern in VGSH in 2023. The pause could cause a rally in the ETF that holds short-term Treasury securities and avoid an economic tragedy worthy of Shakespeare.