The Federal Reserve entered 2023 focused on one central goal; driving down stubbornly high inflation that has plagued the economy since 2021. But over the past quarter, that job has become a lot more complicated than policymakers may want to admit.
Now, the U.S central bank faces a tricky balancing act as it prepares to deliver another interest rate hike in exactly a week from today, against a backdrop of one of the most uncertain economic environments since the Global Financial Crisis in 2008.
In the lead-up to their hotly anticipated FOMC Policy Meeting on June 13-14, several top Fed officials have endorsed the need to continue raising interest higher as ‘insurance’ against inflation. A move that would lift the federal funds rate to a target range of 5.25% to 5.50%, the highest level since January 2001, up from nearly zero early last year.
Those odds surged on Friday, after Non-Farm Payrolls data showed, the U.S. economy continued to defy expectations by adding 339,000 new jobs in May – more than twice the expectations – signalling that Fed’s ongoing efforts to cool the economy and lower inflation has barely made a dent.
In addition, OPEC’s recent decision to cut global supply in an effort to increase Oil prices – has only added to those concerns and made the Fed’s job of lowering inflation a lot more challenging.
The big risk from both an economic and market liquidity perspective is if the Fed hikes more than currently priced in. For a while, the market was convinced that the Fed will soon pivot to rate cuts. But the strength of recent hotter-than-expected economic data as well as OPEC's supply cuts, has once again led to a repricing of rate expectations.
With the Fed's credibility at stake and inflation still well above their 2% target, there is now huge pressure on policymakers to hike rates again at the upcoming FOMC meeting.
However, there’s a problem! Current economic and financial market conditions can't handle anymore rate hikes.
After 10 consecutive hikes, the Federal Reserve has increased interest rates well into restrictive territory.
The further we go into restrictive territory, the more likely it becomes that we begin to see black swan events – just like we have seen recently with the second, third and fourth largest bank failures in history, which have all occurred in past two months.
Those hikes have also pushed mortgage rates up by more than double. Credit card debt has surpassed $1 trillion for the first time ever. Bankruptcy filings are at their highest level since 2008. While overly inflated assets such as real-estate and equities are beginning to wobble.
Most economists have long felt that the Fed has gone one rate hike too far. Now with odds increasing of another rate hike coming next week – the biggest risk is that the Fed may overdo it.
As savvy traders very well know – the time to take action is not at the time of the risk event, but before the risk is realized. Now is the optimal time to prepare your portfolio and get ready to capitalize on the markets next big move.
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