SPY Brushes Off ‘Hawkish’ Fed

The ETF finished Wednesday in the green, even as agency officials projected more rate hikes.

Wednesday morning, ahead of the Federal Open Market Committee’s interest rate decision, markets were convinced the U.S. central bank wouldn’t hike rates. Premeeting probabilities put a 95% chance on the Fed holding the federal funds rate between 5% and 5.25%. 

Those expectations were spot-on. When the Fed’s monetary policy statement was released at 2:00 p.m. Eastern time, the central bank announced it had made no changes to its federal funds rate target. 

Why then did the market swoon in the immediate aftermath of the decision? (In the 10 minutes following the rate decision, the SPDR S&P 500 ETF Trust (SPY) dropped nearly 1%). 

The answer lies in the Fed’s Summary of Economic Projections, a once-a-quarter report outlining Fed officials’ best guesses for how various economic variables will evolve.  

The latest SEP suggests that despite yesterday’s pause, the central bank could hike rates another two times by the end of the year. 

The median projection of Federal Reserve Board members and Federal Reserve Bank presidents puts the benchmark rate at 5.6% at year-end, up about 50 basis points from current levels. 

That was a surprise to most investors. The same fed funds futures that had implied that rates were almost certain to stay steady yesterday, were pricing in just a 60% chance of one more rate increase in July, and nothing beyond that. 

Instead, the latest SEP suggests that the end of the Fed’s rate-hiking campaign could come a little bit later than expected. 

But the SEP projections also raise the question of why the Fed didn’t just hike rates at yesterday’s meeting if most officials believe rates will move at least half a percent higher by year-end. 

A Continuation of the Process  

In his post-decision press conference, Fed Chair Jerome Powell explained why the central bank did what it did.  

He said that yesterday’s pause was the natural evolution of the Fed’s rate hiking process:  

“As we started our rate hikes early last year, we said there were three issues that would need to be addressed in sequence—the speed of tightening, the level to which rates would need to go, and the period of time in which would need to keep policy restrictive.” 

“At the outset, going back 15 months, the key issue was how fast to move rates up, and we moved very quickly by historical standards. Then last December, after four consecutive 75 bps hikes, we moderated to a pace of a 50 bp hike, and then this year, to three 25 bp hikes at consequential meetings.” 

“The decision to consider not hiking at every meeting and ultimately hold rates steady at this meeting is a continuation of that process.” 
 
In other words, just because Fed officials think the end point for the fed funds rate is higher than where the rate is today, doesn’t mean they have to take the rate to its end point immediately. 

After all, when rates were zero in March 2022, everyone knew they were going much higher. But it still took more than a year for the Fed to lift rates up to 5%—and that was a historically rapid pace of monetary policy tightening. 

Time between rate hikes allows the Fed to assess the impact that those hikes are having on the economy.  

That much hasn’t changed; it’s just that the Fed now believes it has the luxury of taking even more time between rate increases given that it’s already hiked rates by 500 basis points and inflation has come down from its 2022 highs.  

Inflation Concerns  

To some, it will be a disappointment that the Fed was more hawkish than expected. In addition to projecting more rate hikes later this year, Powell sounded a relatively downbeat tone when it comes to inflation.  

“If you look at the full range of inflation data, particularly the core data, you just aren’t seeing a lot of progress over the last year,” he said. 

Powell pointed to figures that showed core measures of inflation hovering around 4% to 5%, well above the Fed’s 2% target.  

The median projection in the Fed’s SEP indicates that core PCE inflation will drop to 3.9% by the end of the year, but that’s above the previous projection of 3.6%. 

Powell acknowledged inflation has been more stubborn than he thought it would be and that inflation risks were tilted to the upside.  

Bulls in Control 

In a different environment, the Fed’s projections for two more rate hikes and Powell’s pessimistic tone on inflation might have been enough to push the stock market lower. 

But after initially falling after the Fed’s rate decision, SPY recovered to end the day fractionally higher. 

Perhaps the recovery shouldn’t have been a surprise. Bulls have been in full control of the stock market this year. The S&P 500 has gained 15% in a rally that has caught many investors off guard. 

A realization that the Fed might raise rates another few times probably isn’t enough to derail that rally, not unless something fundamentally changes in the economy. 

Contact Sumit Roy at [email protected]