Sugar High?

The stock market rallied as the Fed said we have reached the neutral rate.
Markets are already anticipating a reversal of rate increases as stocks and bonds rallied.
It’s as if the recession has been cancelled, or maybe it’s over before we knew it was here.
But the Fed emphasized that it is committed to beating inflation now.

It sure looks that way as a brief comment by Fed Chair Powell on Wednesday sent the stock market flying and longer-term interest rates tumbling. The comment that lit the fuse was rather benign on the surface. “So, I guess I’d start by saying we’ve been saying we would move expeditiously to get to the range of neutral. And I think we’ve done that now. We’re at 2.25 to 2.5 and that’s right in the range of what we think is neutral.”

By way of explanation, the neutral rate of interest is the theoretical rate that is neither restrictive or accommodative to economic conditions. The Fed had never previously defined what they thought the neutral was. Although the Fed made it clear that further rate increases were probable, the stock market took this comment to imply that it would not be very long before the Fed reversed policy and began to cut interest rates again. Lower rates = higher valuations. Cue the stock market bulls! Suddenly, it appears the stock market believes that a recession would be mild, if there is a recession at all.

An oversold market, as it was entering the Fed meeting, is always looking for a reason to rally and Mr. Powell gave them a reason. We are not believers in the rally, at least not yet. We focused on the sentence that followed the one above: “So, the question is how are we thinking about the path forward. So, one thing that hasn’t changed– won’t change is that our focus is going to continue to be using our tools to bring demand back into better balance with supply in order to bring inflation back down. That will continue to be our overarching focus.” Our view is that Powell made it very clear several times that inflation needs to be tamed and it needs to be tamed now. Later in the news conference he added this comment: “Let me put it this way, we do see that there are two sided risks. There would be the risk of doing too much and imposing more of a downturn on the economy than was necessary, but the risk of doing too little and leaving the economy with this entrenched inflation, it only raises the cost. If you fail to deal with it in the near term, it only raises the cost of dealing with it later.” We interpret that as saying that rates aren’t coming down until the 2% inflation target is in view and that is clearly not the case today with inflation running at about 9% and core inflation at about 6%. The pile of sugar the market sees in Powells’ comments may turn out to be a pile of salt.

Our View

Because of the aggressive Fed responses to past problems, recessions are now viewed as never long and rarely steep and it has paid-off for traders to aggressively anticipate Fed moves. There is just one problem. This episode is unlike all the others. This time we are dealing with inflation and that changes the rules that have been in place over the last several decades. At this point, it appears that headline inflation might get down to 5% or so by year end. That is still a far cry from 2%.

The Fed’s message is that they are willing to keep interest rates higher for longer in order to get inflation back under control and that risks markets jumping the gun on rate reductions.

On the chart below, the red line is the consensus Fed forecast (known as the dot plot) for where they expect the Fed Funds rate (the very short-term interest rate) to be at the end of each year. Note that based on the increase this week, Fed Funds are targeted at 2.50% to 2.75%. The black line is where the bond market expects rates to be based on the price of Fed Funds Futures.

Although the Fed expects to raise rates between now and the end of the year and then raise rates a bit more in 2023, the market expects those rates to reverse in 2023. An added wrinkle not reflected here is the impact of Quantitative Tightening (QT; the Fed reducing its holdings of Treasury bonds and mortgage securities), which should have an impact similar to raising interest rates. Our recent Palumbo Pulse Podcast with John McClure of ProfitScore showed the positive effects the Fed had in risk assets during their easing, so it’s not a stretch to assume QT will create the opposite effect.

What we find most interesting is that the stock market appears to be rallying as if interest rates are headed back down to the very low levels we’ve experienced over the last 10+ years. The bond market expects the Fed Funds rate at the end of 2024 to be precisely where it is today, about 2.5%.

Ironically, the more the stock market rallies, the less the odds of a rate cut. The purpose of raising interest rates is to slow demand. To slow economic activity such that supply and demand are in better balance. Part of that process is to tame the asset price inflation in the stock market, real estate, etc. The stock market rally actually works against what the Fed is trying to achieve, which makes us believe it is more likely they will keep rates higher for longer.

This has been an impressive rally, no doubt, but we are still in the camp of this being a bear market rally, not a new bull market. While we could be wrong, we’d like to see the white of a turnaround’s eyes, and we do not see that yet, so we remain risk-averse in our portfolio positioning. We expect volatility to continue.

As a reminder, our portfolios are not predicated on our macroeconomic outlook. We continue to maintain adequate diversification across the portfolio and rebalance portfolios as necessary to maintain that diversification. We continue to feel the next few years will present challenges for investors, especially in the traditional asset classes, and thus we continue to seek out alternative investments and specialized strategies we can invest in to further diversify client portfolios.