By Brian Reilly, CFA
President, Ehlers Investments

It may sound anticlimactic, but there are regularly important moments in financial markets where everyone expects nothing to happen.  Such was the case for the announcement made by Federal Reserve Chair Jerome Powell at the conclusion of last Wednesday’s policy meeting of the Federal Open Market Committee (FOMC).  As expected, the FOMC left the target range for the federal funds rate unchanged at 5.25% – 5.50%.

Before the beginning of the calendar year, market sentiment generally gravitated towards as many as six, quarter-point cuts to the federal funds rate.  The March meeting marks the fifth straight FOMC meeting with no action on the fed funds rate and the second of 2024.  During Chair Powell’s press conference, he reiterated the Fed’s stance on the “data-dependent” framework for future decisions regarding interest rate policy.

Recent economic and inflation data have eased some of the perceived pressures on the FOMC and its dual mandate of maintaining full employment and achieving price stability.  While February’s read on employment showed a gain of 275,000 jobs, which was hotter than anticipated, prior months were revised down significantly.  The unemployment rate increased nominally, and wage growth was weaker than expected.  Similarly, there was a mixed story on inflation for February.  Consumer prices, as measured by the Consumer Price Index, increased at an annual rate of 3.2% in February, up from January’s 3.1%.  The Fed’s preferred measure of inflation, the Personal Consumption Expenditure index, increased at a year-over-year annual rate of 2.4% for January.  All these measures remain higher than the Fed’s 2.0% inflation target, albeit much lower than at many points throughout 2023.  The argument could be made that the trend is currently the Fed’s friend relative to maintaining the status quo of its monetary policy philosophy, because economic growth indicators haven’t materially suffered in the face of its hawkish stance and an inverted yield curve.  The Fed can sit back and let the data be its guide without broader market pressures building towards a boiling point.

The fed funds forecast of FOMC members preserved a bias towards three, quarter-point cuts through the end of 2024.  The markets, as measured by fed funds futures pricing, are generally in line with these expectations.  However, those sentiments have materially shifted over just the past month.  The CME’s Fedwatch tool now indicates a 13% probability of a quarter-point cut at the FOMC’s May meeting, down from 25% in February.  The June meeting is now in the market’s crosshairs for a 25-basis point cut to the target range, with a probability of 64%, and a 27% chance of no change.  In February, these probabilities were 52% and 33%, respectively.  There are nearly equal probabilities of 30% for a full 75- or 100-basis point reduction in the fed funds rate through December of this year, which are both largely in line with the prior month’s expectations.

Market reactions at the time of the announcement were mixed.  Equity markets rallied, with broad indexes up over 1.00% on the day.  Interestingly, interest rates across the maturity spectrum were mostly unaffected.  There has been some level of “flattening” across the yield curve in the last month, as fixed-income markets seemed to have priced in the notion of rate cuts being pushed out to later in the year, and a “higher-for-longer” posture taken by the Fed.  Notably, the 2-year Treasury yield is about 40-basis points higher since the beginning of February.  The 10-year Treasury has remained in a range of 4.20% – 4.30% over this same period.

Perhaps even more meaningful were Chair Powell’s comments regarding the Fed’s balance sheet.  The Federal Reserve’s balance sheet ballooned during the “Great Recession,” as it stepped in to provide non-traditional support to financial markets during a period where it had already reduced its policy rate to near-zero.  When the Fed buys securities in the open markets, it creates reserves in the banking system that provide liquidity to the broader financial markets.  Essentially, money is created, and the Fed similarly creates a sort of artificial demand for securities like U.S. Treasuries, thereby propping up their price and holding down the inverse of bond prices in the form of interest rates.  This has the combined effect of building liquidity in the banking system and pushing down rates across the interest rate spectrum, not just overnight rates.

The balance sheet grew from about $900 million in 2008 to about $4.4 trillion by mid-2014.  It remained there until 2017, then declined to just under $4 trillion by late 2019.  Not long after and amidst the economic decline associated with COVID-19 measures taken at national and state levels, the Fed re-engaged in a period of balance sheet expansion with total assets spiking to nearly $9 trillion by mid-2022.  Shortly after reaching that level, Fed officials announced they would back away from “emergency” measures (seems like we’ve been in an emergency for 15 years) and begin to allow for balance sheet “runoff,” meaning they would not be reinvesting the cash flows from bonds maturing in their portfolio.

The balance sheet now stands at roughly $7.5 trillion, as the Fed has a stated objective of allowing roughly $60 billion of U.S. Treasuries and $35 billion of mortgage securities expire each month without reinvesting those dollars.  With regard to the balance sheet, Powell stated Wednesday that, “It will be appropriate to slow the pace of run-off fairly soon.”  Powell offered no specifics on the timing or scope of that shift– only that the matter will be a topic of debate within the FOMC over its next few meetings.  Market observers believe there may be announcement as early as the May meeting, which is the next FOMC meeting on the calendar.  Interest rate markets seemed unphased by these statements, so it’s probably logical to assume the Fed has been doing a reasonable job of communicating its policy prerogatives over the last few months.  There was realistic and meaningful concern about the Fed being able to thread the needle of removing policy accommodation without serious, negative impacts to the broader economy.  While the game is not finished, the Fed is clearly winning as we head into the final half.

As we’ve mentioned in some of our prior commentaries, should market expectations prove accurate, public funds investors need to identify a long-term perspective to create sustainable income within their investment portfolios.  History has proven that the inception of a rate-cutting cycle can be difficult to spot, with short-term rates declining precipitously over a number of months to follow.  If you’re presently relying on money funds and cash-like products to generate 5.00%+ yields for the majority of your portfolio, you should consider speaking with an Ehlers Investment Advisor about crafting a durable plan to take you into through next few years, using a more laddered approach to income generation and asset preservation.

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