A continued focus on fixed income versus equities 

AT ITS May policy meeting, the US Federal Reserve raised the federal funds rate 25 basis points (bps) to a target range of 5.00–5.25 per cent. Looking back, the Fed has raised rates 500 bps in around 14 months, which is substantial not only in terms of the amount of tightening, but in the pace as well. We are clearly seeing how this tightening cycle has impacted the more interest-rate sensitive areas of the economy, such as housing, but also how it has caused strains in the banking system.

We believe the May increase could be the last we will see in this tightening cycle – at least for some time. There is clear evidence that economic slack is building within the US economy, and we believe the Fed has sufficiently moved into restrictive territory on a path to achieve its 2 per cent inflation target. In addition, lending conditions are also tightening and doing some of the work for the Fed. The markets are now pricing in three to four rate cuts through the Fed meeting in January 2024. We are a little bit more cautious about this, though, and believe the Fed needs more time to take a pause and see how conditions evolve in the overall economy before acting.

Although the initial decline from the peaks for both headline and core inflation came relatively quickly, which set the market up for an expectation of the Fed getting closer to its target, we are finding that there is still substantial excess liquidity in the economy. Consumer spending is starting to wane, but core inflation – both consumer price index (CPI) and personal consumption expenditures (PCE) – is proving to be stickier and a challenge for the Fed. The labour market has so far continued to be resilient, putting upward pressure on wages. We think progress is being made, but it will be closer to the fourth quarter of 2023 where we might see real evidence that core prices are getting to the point where the Fed can start to contemplate removing its restrictive policy and get a bit more neutral. With loans contracting a little bit, particularly within regional banks, small- and medium-size businesses will likely see a greater negative impact.