BY: Jim McElroy
Will They, Won’t They, When Will They?
We’re talking about the Fed, of course. Will the Fed lower short-term rates, or will they keep them at the current range (5.25% – 5.50%) for another six or more weeks to see if core PCE inflation continues to decline towards a desired 2% level? A less popular question, but nonetheless a valid one, is how will the Fed respond if inflation remains mired at its current 2.85%, or worse, accelerates; or how will it respond if the unemployment rate, currently at 3.9%, begins to approach 5%.
The actions of the Fed, both actual and expected, have always had an impact on financial markets. The current state of market attention to Fed pronouncements, however, seems to us more intense than what we have experienced in recent years. Perhaps it has something to do with the greater candor of the current chairman over his more recent predecessors. Or it may be that this elevated sensitivity is the traumatized result of the unusual conditions experienced over the last four years: in true “House-That-Jack-Built” fashion, the global pandemic produced a deep recession, which induced the government to spend enormous amounts of money to avoid an even worse depression, which caused the highest inflation rates in over forty years, which led the Fed to embark on the steepest rate tightening since the 1980s, which triggered a bear market in stocks and left us with overnight rates of 5.25%, the highest in a generation. With this history over the last four years, it’s no wonder that the markets are preternaturally focused on communications from the Fed.
Following its March 19th and 20th meeting, the Fed acknowledged progress against inflation, in spite of recent positive price pressures, and reaffirmed that the committee still expects three rate cuts before year end. There are six more FOMC meetings before year end, and assuming that these rate cuts will be in .25% increments and that they will coincide with the conclusion of three of these meetings, the committee must be planning to begin reductions by mid-September, if not sooner. The market seems to be placing its bets that the Fed will begin reducing rates at the June 11th and 12th meeting: the yield on the two-year US Treasury Note (4.5%), often used as a proxy for the Fed Funds rate in the not-too-distant future, is indicating three .25% cuts from the current 5.25%. But the Fed makes no promises.
Promises or not, the markets seem confident that the Fed will win its battle against inflation and still avoid a recession. In the fixed income markets, the difference in yields between Baa corporate bonds and ten-year Treasuries, the so-called credit spread, stands at 1.6%, the lowest spread in almost fifteen years and a clear vote of confidence in a strong economy. And despite the twenty-three-year high in overnight rates, equity markets are on a tear: the S&P 500, sporting a P/E multiple of over 21 times expected earnings, well above the thirty-year average of 16, is up 10% for the first quarter — the best first quarter performance since 2019 — and is hitting all-time record highs. Nevertheless, the simultaneity of these two conditions — a booming stock market and high short term interest rates — is not sustainable: either rates, the stock market or both will fall. The hope is that the Fed can soon declare victory over inflation — a PCE core rate headed for 2% or less — and reduce overnight rates accordingly. A delay of more than three months in declaring victory over inflation, or worse, an unexpected acceleration in inflation, will not be received well by investment markets.
When so much interest is attached to a single event, every data release that might shape that event, or nuanced comment/rumor that might reveal a particular bias towards that event, takes on considerably more importance than it would under less focused conditions. In the current charged environment, an alteration in the Fed’s timetable of rate cuts and/or a change in inflation expectations would have a noticeable effect upon investment markets, either positive or negative, depending on the direction of the surprise. Volatility would increase dramatically. So far this year, there has not been much in the way of volatility in the stock market: as measured by the VIX index, daily volatility in 2024 has averaged 13.5%, a significant decline from the five-year average of 21.2%. If events should change the Fed’s messaging on interest rates or on the economy, we would expect daily volatility to revert to the mean.
None of this is meant to suggest that the stock market is teetering on the edge of a precipice. We only wish to warn against the dangers of complacency. Markets move prospectively: they are always in forecast mode. Currently, the forecast is that the Fed will accomplish that much sought after “soft landing”, the simultaneous realization of 2% or less inflation and something approaching full employment. It is certainly possible that this forecast will come true. From the end of the Great Recession (July 2009) to the onset of the pandemic, the Fed oversaw a decline in the unemployment rate from 9.9% to 3.5% and kept annual inflation (core PCE) largely between 0% and 2.5%. Of course, with the pandemic, the unemployment rate soared to 13.2% but subsequently returned to pre-pandemic levels (3.7% to 3.9%). The problem is with inflation: the core PCE numbers since the pandemic have remained elevated — an average of 4% with a range between 1.0% and 7.5% — and seem to be moving in the opposite direction from the Fed’s target of 2%. Recent remarks from Fed Chairman Powell have suggested that the Fed plans to be patient with the “sticky” inflation numbers, but one wonders for how long it will tolerate consumer prices that stubbornly increase above target levels.
Anecdotally, there is great euphoria among market participants. Analysts are describing upcoming reports on corporate earnings as “earnings revisions nirvana”. The market for IPOs (initial public offerings) is booming. Junk bonds — bonds rated below investment grade — seem to be multiplying. In response to the prophets of “hard landings”, some pundits are writing now about “no landings”. We are in what is known as a “risk on” market. And perhaps this enthusiasm is well grounded. We suggest, however, that investors might wish to temper their enthusiasm — the Fed can spoil the party with just a few words — and remember the risk mitigating qualities of diversification.
Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.
