The Fed’s “Real”ly Hurting Risk Assets
Stock markets moved sharply higher into mid-August, hoping for a shift towards an easier Fed in the fourth quarter and in 2023. Real interest rates were falling into Chairmen Powell’s speech in late August. Jerome Powell’s 8-minute speech at Jackson Hole on Friday, August 26th, threw cold water on that. The Fed’s September 22nd FOMC release and the question-and-answer session that followed with Chairmen Powell put further upward pressure on real interest rates and downward pressure on all risk assets.
There was only one winner on the day. The U.S. dollar hit a new decade high. For now, the dollar remains the world’s currency of safety. Risk assets don’t like this at this stage of the business cycle. With every market ex, the U.S. closed at the time of the FOMC release, the final 2 hours of trading was one of the bigger whipsaw sessions of the year, with stocks rallying over 3900 but closing on their lows and the S&P500 falling back below 3800.
I am Chris Perras with Oak Harvest Financial in Houston and welcome to our weekly stock talk podcast, keeping you connected to your money. Before we get into this week’s topic, “The Fed playing catchup to inflation has “real” ly hurt risk assets” all year.
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While Powell has repeatedly said that the Fed and its committee is, “data dependent,” the government data they review continues to show elevated and stubborn inflation. The Fed tends to rely on data collected by the Bureau of Labor and Statistics, which has historically lagged what’s going on in the real-time economy by months and quarters, both on the way up and on the way down. The release of August CPI data on September 13th, exceeded analysts’ expectations and set off a cascade down in stocks and up in Fed rate expectations.
Powell’s words out of the September FOMC meeting on September 21st gave hope for about an hour that the Feds interest rate path in the fourth quarter would be data-dependent. However, the computers took over trading the Fed’s “dot plot” interest rate forecast, which was more hawkish than markets expected. The FOMC’s talk suggests another 75bps and 50 bps in hikes this year, taking the monetary policy into a very restrictive place. Viewers recall that the Fed’s Dot Plot has a very poor track record in predicting exactly what the Fed will end up doing.
Only a year ago that DOT Plot and Fed Funds futures said, the Fed would raise rates once or twice in 2022 to about fifty basis points or maybe 75 basis points. They have already raised rates three times in the last five months by seventy-five basis points at a time.
In his remarks, Fed Chairmen Powell said, “We have to get inflation under control.” If one believes the Fed’s 2.5% neutral rate and real time inflation breakeven rates of 2.25-2.5%, the Fed is already achieving their inflation goal. It already is, but they don’t see it yet in their own government BLS data. This hawkish talk has caused 2-year treasury rates to spike over sixty basis points since the Jackson Hole speech. These yields now sit near 4.1%, a risk-free rate starting to compete against stocks and other yield instruments for the first time in a decade.
Outside the end of the Volcker years in the 1970’s, short-term interest rates are rising faster than at any point in the last 70 years. Only 1994 comes close when they doubled by 300 basis points in 12 months. Putting this in perspective, the pace of change is about the same but opposite direction as how fast the Fed cut rates in the wake of the Great Financial Crises in 2008. Recall back then, while the leaders in the new bull market appeared in October and November of 2008, that it took until March of 2009 before the overall financial markets bottomed and pivoted higher. Our team does not see that kind of credit event or market risk inherent in the current market makeup.
Remember, these monetary policies work with a lag both on the way up and down. The stimulative Covid monetary response in the second quarter of 2020 took 6 to 9 months to work its way into the economy. That’s even though the stock market had already anticipated its effects.
- Stocks moved sharply higher in advance of the economic recovery that happened. Likewise, the stock markets have moved down throughout 2022 in front of the Fed’s monetary policy tightening and its economic effects.
- They have anticipated slow to negative economic growth in the first half of 2022 against near impossible comparable growth in the first half of 2021.
- Economic growth, which has come in negative for the first two quarters and the historic definition of a recession, is now forecast to barely grow in 2022. The Feds forecast of .2% growth in 2022 and then 1.2% in 2023. The rapid rate increase will almost certainly mean higher unemployment, lower wages, and likely a few more quarters of negative growth until inflation heads lower.
- Powell emphasized that higher unemployment is going to be an “unfortunate cost of lowering inflation.” He followed this up with “but failure to restore price stability would mean far greater pain longer term.”
The Fed Strikes back:
The Fed raised rates by seventy-five basis points last week. That’s the third time this year. Over the previous 30 years, the Fed only raised rates by ¾ of a percent one other time. In November of 1994, Alan Greenspan announced a rate hike from 4.75 to 5.5%.
Recall, much like this year, he had started raising rates early in 1994 when rates were 3%. By the time Greenspan raised by seventy-five basis points in late November 1994, the stock market had already been declining for about ten months from its absolute peak returning to where it was 18-24 months earlier. Unfortunately, this 18-24 month round trip in stocks is a common theme when the Fed is tightening monetary policy in order to combat inflation or slow growth.
The Fed raised interest rates from 3% to 6% from February 1994 to February 1995, including the November 75bps raise. Take a look at the chart of the S&P500 in 1994. The circles are the beginning of the Fed tightening cycle, and the one in November was Greenspan’s 75bps increase. As one can see, the stock market was already heading up and to the right before Greenspan “pivoted” to the notion of possibly cutting rates in the second half of 1995. The markets were most interested in the rate of change in monetary policy.
So, the current Fed is taking the current inflation problem deathly seriously with these 75bps rate hikes. Why? It wants to make sure inflation expectations don’t become unanchored. It means that the Fed doesn’t want consumers or businesses to expect prices to rise in the future.
While the real-time markets see inflation fears and risks subsiding, with Powell’s FOMC speech, asset investors are afraid the Fed doesn’t care and are set on a path of causing a recession to meet their inflation-fighting goals. As we have discussed a few times this year, the main cause for the broad downturn across all assets, including commodities, is the market’s expectation of higher real interest rate yields, the second component of interest rates, not so much their inflation fears.
Does the Fed want to throw our economy into a recession to tame inflation? Inflation that, by all accounts, they created much of by staying too easy with their own monetary policy in 2021? And the parts of inflation they don’t control, like commodities and energy prices, are already falling fast out of their control? I don’t know. That seems draconian to me, but I don’t run the Fed.
Powell all but said they are willing to bypass a soft landing. But with so many job openings for so few workers, would a recession look like those recessions in the past? A full-employment recession?
What I do believe is that as soon as the markets feel that the Fed sees the pace of inflation slowing, whether that’s in the real-time data series we watch or the lagging government BLS data, like a monthly CPI print dropping, and the pace of their rate increases begins to slow, it will likely be reflected almost immediately in a peaking of real-interest rates across the interest rate maturity curve. The real-world data that lead shelter PCE by 6 to 8 months are now declining sharply. Things like consumer inflation expectations and commodity prices like lumber or copper have tumbled.
- Here are charts from Ed Hyman showing the rollover in real-time New York rents and apartment surveys showing we are past peak. Unfortunately, the Fed focuses on slower BLS data series.
What I do believe is that as soon as the markets feel that the Fed sees the pace of inflation slowing, which points toward Fourth quarter of 2022 in the BLS data, this will likely lead to a collective exhale of relief by investors across stocks, bonds, commodities and real-estate, and a retreat in market volatility around almost all asset classes. Much as we saw from mid-June through Mid-August, a collective exhale would likely cause a collapsing of future volatility expectations, calmer markets, and a significant upward rally in stocks.
Amongst the wreckage in risk assets last week, a few signs are appearing that we are quickly reaching what could be maximum negative normal seasonal extreme in the third quarter of an election year. Three things are showing up. 1-sentiment indicators, such as the AAII survey, are sporting the least bulls and most bears in almost 30 years, 2- the market is nearing oversold levels again based on technical indicators like MACD’s and oscillators, and 3 – the late 2021 hedgers, who foresaw a 2022 correction, which has morphed into the first bear market in years, are starting to slowly nibble at reversing their insurance policies which had extended into early October of this year. The first smart money group that went into the fear trade back in the fourth quarter 2021 is slowly beginning to ease out of that position.
Investor sentiment is now bordering on somber. According to Ned Davis research, the bearish narrative and sentiment has been around now for the third longest time in the last 30 years. Their data is now at 112 consecutive trading days. The only two other stretches that were longer were in 2002 and the second half of 2008. These, of course, were part of two secular bear markets.
- The only other one to last more than one hundred trading days was during the 2011 European sovereign debt crisis.
While returns in all three cases were negative for a few months after we passed the 100-day mark, the median return a year later was up almost +20%. A 20% return would currently clock in around S&P500 4550-4600 in mid-2023. To put that in perspective, that is about where we were a year ago, nearing Halloween. That being said, the NDR historical data also shows that waiting for sentiment to exit extreme pessimism is also a profitable strategy. Exiting extreme pessimism, not waiting on optimism to return.
Historically bear markets have been in the rear-view mirror by a month or more prior to investors leaving the extreme side of pessimism, and we know that stock market bottoms come months before the economic data shows meaningful and sustained upturns.
Summarizing it all:
It’s been a mess this year and a difficult environment for the stock and bond markets as the market wrestles with how slow the economy will get as the Fed continues its inflation fight. The real-time data behind the scenes say that the Fed is succeeding in lowering inflation. Investors want to know that the Fed sees it, believes it too, and is willing to take their foot off the gas of monetary policy tightening as inflation slows. For now, markets remain frightened that the Fed is driving the monetary bus in the wrong direction too fast. Inflation is rolling over.
Zillow reports that August apartment rents have declined in many markets across the U.S. Food prices are beginning to decline. Meat and dairy prices at my local supermarkets are on sale for the first time in 2+ years. If the upcoming inflation reports that the Fed follows, that typically are slow to react, and lagging start surprising, better than expected? That would be the start of a true turnaround in risk assets.
The impacts from recent Fed rate hikes are being quickly passed on to the financial markets and other markets such as the housing market and other credit markets such as junk bonds. Citrix Systems bond underwriters just had to take a large loss on billions of debts they held in a bridge loan for that deal because interest rates have moved so fast against them. Unfortunately, areas of the real economy that the Fed is watching, such as jobs and wages, have yet to feel the full impact of these aggressive rate hikes.
Viewers, Listeners they will be impacted. As the Fed themselves say, Monetary policy actions tend to influence economic activity, employment, and prices with long and variable lag. For the last six months and particularly since Jackson Hole, the Fed has been using harsh rhetoric and forward guidance because they know it can have an immediate effect on financial markets and the economy without a lag. Unfortunately, that brings about higher market volatility that few longer-term investors who are not traders enjoy. I know that I am not enjoying 2022 any more than other longer-term investors.
If the ongoing market volatility is making you feel uneasy, give us a call, and schedule a meeting with an Oak Harvest advisor. Our team does have insurance-based tools that do not have the volatility of public markets. However, we remind you, that these investments may also have lower long-term expected returns.
At Oak harvest, we think our clients are best served by us helping them plan for their future needs, instead of focusing on the past. The future and stock markets are always uncertain and that is why our retirement planning teams plan for your retirement needs first, and your greed’s second.
Give us a call to speak to an advisor and let us help you craft a financial plan that helps you meet your retirement goals. Call us here at (877) 896-0040 and schedule an advisor consultation. We are here to help you on your financial journey into and through your retirement years.
– I’m Chris Perras and from everyone here at Oak Harvest Financial Group, Have a blessed Weekend.
CFA®, CLU®, ChFC®
Chief Investment Officer, Financial Advisor
Chris is a seasoned investment professional with over 25 years of experience working with some of the most successful money management firms in the world. Chris has made it a point in his career to adapt as the market landscape changes, seeking to utilize the appropriate investment strategy for a given market environment. His transition from managing billions of dollars at the institutional level to helping individuals and families retire is guided by a desire to see first-hand the impact he is making in the lives of clients at Oak Harvest.