2022 was an eventful year to say the least. War in Ukraine, its subsequent impact on energy markets, US elections, COVID management and real estate contagion in China, and inflation both domestically and abroad.

While quite a bit has happened in 2022, one thing sticks out like a sore thumb that (in many ways) incorporates all of these variables, and is likely to have the biggest impact on markets in 2023: Can inflation be brought under control?

This does not compute

Recent data suggest that no one really knows the answer... yet at least. Why do I say that? Because of the disconnect occurring in the bond market.

What is that disconnect? The current yield on the 10-year US Treasury Bonds and the anticipated Fed Funds Rate in early 2023.

For historical context, below is a graph of the 10-year Treasury yield (blue) vs. the Fed Funds Rate (orange) going back to 1962:

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Rather than focus on the level of rates (Y-Axis) I’d like to draw your attention to the relationship between the Fed Funds Rate (orange) and the 10-year Treasury Bond yield (blue). The Fed Funds Rate is almost always below the yield for a 10-year Treasury Bond. This makes sense as you should be compensated more for lending the government money for 10-years compared to holding a Money Market fund that allows you to sell at any time for $1.

Currently, the rates are just about even (as illustrated by the far-right side of this graph), but that will change later this week when The Fed raises its benchmark rate again.

What are markets anticipating?

The Chicago Mercantile Exchange has a nifty tool they called the CME FedWatch Tool that calculates the anticipated Fed Funds Rate based on current market participant positioning. Here is what that data currently anticipates (as of 12/12/2022):

In short, the expectation is that the Fed Funds Rate will be at/around 5% sometime in early 2023, which means money market yields are expected to be close to 5% as well, an unthinkable level 12 months ago.

Meanwhile, the yield on the 10-year Treasury continues to hover around 3.5%, not only lower than the expected Fed Funds Rate, but much lower. This is an indication that markets don’t think inflation will stick around forever, as if it does, this rate would need to be much, much higher than 3.5% to adequately compensate investors.

From a statistical standpoint, the level of disconnect markets are expecting (Fed Funds Rate +1.5% vs. 10-year Treasury bonds) has only happened three times in the past: The late 1960’s, mid 70s, and early 80s:

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One thing today has in common with those time periods: Persistent inflation well above 3%.

What happens next?

With the current inflation and economic dynamics, I see this going one of three ways:

1. The Fed backs off its current rate hiking schedule due to a spike in unemployment/concerns about a recession and accepts a higher inflation target (say ~3% moving forward).
2. The Fed refuses to back off its rate hiking schedule to ensure that inflation is defeated regardless of economic contraction (this would be the “Fed hikes us into a recession” outcome).  
3. The economy remains strong, inflation remains elevated and persistent, and the 10-year rate rises steadily to reach parity with or climb higher than the Fed Funds Rate.

The biggest concern amongst investors is item two, where The Fed has no choice but to remain steadfast (maybe a little stubborn) in its effort to return inflation to its ~2% target. If The Fed is forced by elevated inflation to continue down its current path, it seems all but assured that an economic slowdown will happen. From a historical perspective, recessions occurred during each of the three timeframes circled above.

How might markets react?

During the three prior occurrences notated above, the US Market (as measured by CRSP 1-10 market index) had an average return of -0.50%. Not great, but also not suggestive of any major market deterioration on the horizon. Put bluntly: Market performance and economic activity are not the same. The best example of this is… 2022. The economy has remained strong this year, yet the S&P 500 is down around 17%. I doubt anyone selected “stock market has its worse calendar year since 2008 and 4^th quarter GDP will be estimated at 3.2% (per GDPNow)" on their predictions card 12 months ago.

What should investors consider?

1. Make sure your safe/stable money isn’t being taken advantage of in your bank accounts: High-yield savings accounts (Ally, Amex, Marcus, etc.), money market funds, ultra-short-term bonds (think 6, 12, and 18-month maturities), and even brokered CDs currently offer very attractive yields (3% or MORE annually) compared to standard savings/checking accounts and long-term bonds. This dynamic won’t last forever, so enjoy it while you can, and make sure you are positioned to benefit from current conditions.
2. Continue investing excess cash flow: Markets don’t wait for an “all clear” to commence a rally. While markets have recovered from the 2022 lows, we are still looking at the worst calendar year for the S&P 500 since 2008. While I have no idea where the market is going in the short-term, buying when the market is down (and in accordance with your specific plan) has been a profitable endeavor during similar periods.  
3. Stick to your long-term plan: Two years from now, this article, and the current dynamics of the yield curve, won’t matter as much as sticking to your specific long-term plan.

As for me, I’m doing the three things listed above. What kind of advisor would I be if I didn’t eat my own cooking.

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Have questions about how your plan is impacted, schedule a call below.

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Disclosure:

This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.

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