Celebrating 17 Years of Service

July Newsletter

Jul 13, 2023


One of the tools that the Federal Reserve uses to control monetary policy is the federal funds rate. It can increase the federal funds rate to slow economic activity and curb inflation. The inverse is true if the Fed is trying to encourage borrowing and spending to stimulate an economy. If the Fed tightens monetary policy too far, it can cause the economy to contract, potentially leading to a recession.

It appears that the recent June rate hike pause by the Fed may have been premature considering the resilience of both the economy and inflation. This is despite the Fed having already raised rates by 5.00% and the subsequent inversion of the yield curve (generally a sign of recession). The size and pace of recent rate hikes have resulted in one of the fastest rate hiking cycles in history. Last year’s increases led to a bear market in stocks, bonds, and real estate, but no recession ensued. This year, the markets, particularly tech growth stocks, rallied in anticipation of the Fed pausing its interest rate increases. This optimism was premised on the expectation that following the pause announced in mid-June, the Fed would stop increasing rates and start reducing them by late 2023 or early 2024.

Today, inflation is still high, but it has been coming down monthly, adding support for the markets. Core inflation, which strips out the volatile food and energy categories, recently slowed more than expected to a 4.8% annual pace from 5.3% in May. This is still well above the Fed’s 2% target, and reaching this level looks out of the question for 2023 and probably won’t happen in 2024.

So, What’s Next for the Fed?

As noted above, the Fed paused its current rate hiking cycle in June for the first time since early 2022. This was despite most Fed policy members believing they would end up raising rates by another 0.50% by year’s end. Perhaps the Fed, wary of unsettling the market, opted for a pause hoping for slower inflation despite a robust economy. We speculate that banks, along with leveraged real estate investors (particularly in commercial real estate), may be grappling with the rapid increase in rates over the past year.

The Fed’s preferred inflation measure, Core PCE, stands at 4.4%, still well above its stated 2% target (see chart below). We expect the Fed will have to increase rates above the current level if it wants inflation to decline to the 2% level.

Our opinion, and it’s currently an out-of-consensus opinion, is that the Fed may get inflation into the 3-4% range and call its job done. However, inflation is not going away as global central bankers are finding out. Inflation will not decline until unemployment rises. Unemployment is not what the White House or voters want, not in an election year! Interest rate hikes tend to be unpopular in an election year, particularly when the President is vying for a second term in office.

We anticipate U.S. economic growth to continue and to surprise to the upside versus consensus expectations. Accordingly, the odds are good that the Fed will have to lift rates above the 5.6% peak projected in the dot plot and keep rates higher for longer than markets are currently pricing. However, further rate increases could face political headwinds.


The recently released Manpower Employment Survey of large global companies revealed broad strength in hiring plans for the third quarter, which does not indicate an impending recession (see chart below). On the contrary, it signals stronger demand for workers in the future. Despite a contraction in global manufacturing, layoffs from big tech companies, and pandemic-related unemployment, hiring intentions have strengthened. This is bad news for bond bulls (expecting declining interest rates) and inflation-fighting central bankers, but it also offers an opportunity to ride up the yield curve to higher longer-term bond yields for investors.

It reinforces our view of using the pressure on interest rates to ride up the yield curve to higher longer-term bond yields. We have been “bond bearish” for some time and as a result have kept bond maturities near the short-end of the yield curve and receiving higher yields on our cash. If the Fed were to cut interest rates inflation will increase. When investors realize that the core inflation rate is not following the headline rate down to much lower levels, bond yields will rise even further putting downward pressure on stocks and real estate though likely not as bad as last year.

We think that will provide an opportunity to deploy more cash into equities. In the meantime, cash and cash equivalents are finally earning a  reasonable rate of interest, with treasury bill rates north of 5%.


Inflation, specifically headline inflation, will continue to lower but we’ll see less of a decline in core inflation. After a cooling during the 3rd   quarter, bond yields may rise to new highs. The Fed will be forced to increase interest rates to contain inflation. This will cause short-term selling in stocks and real estate. It will present an opportunity to deploy our cash resources. The inflation genie is out of the bottle and talking it back in the bottle won’t work. Rates will have to be higher and stay higher than inflation to bring it down, this is not for people trying to get reelected.


All 23 large banks passed the latest stress test. The test is to see how these “too big to fail banks” would do under extreme economic stress. The question is “do they have enough capital to absorb losses if unemployment went to 10%, the stock market declined 45%?” This year they were also tested under global recession conditions, including a scenario where home prices and commercial real estate each plunged 40% in addition to unemployment at 10% and stocks down 45%. These scenarios are meant to “stress test” the banks during periods of extreme volatility. They all passed, and even with losses of $541 billion, the banks still had capital equal to 10.1% of total assets and above the Fed’s minimum 4.5% requirement. 

The strongest bank, with the best capital ratio under those stressed conditions, was Charles Schwab, and the weakest was Citizens Financial.

The Fed runs the bank stress test to see how much capital is available after reaching the minimum 4.5% capital requirement to buy back stocks to pay dividends. Since the release of the report in June, five of the 23 banks tested announced increases to their dividends, and there may be more to come.

CHART OF THE MONTH – Thoughts on Consumer Spending

During the pandemic, the federal government implemented several large-scale cash-transfer programs, including three rounds of economic impact payments for eligible households, the expanded Child Tax Credit, and enhanced unemployment insurance. These measures empowered consumers to save and spend more, bolstering the economy.

Excess savings by consumers have remained high, supporting economic spending. However, with the resumption of student loan payments around the corner, this may dampen consumer spending.