"Every job looks easy when you aren’t the one doing it” – Jeff Immelt, former CEO, General Electric
The Federal Reserve’s benchmark rate started the year at 0%. Following the September 2022 meeting, it is now at ~3%, the highest level in nearly 15 years. More importantly, The Fed has signaled that it will continue increasing its benchmark rate for the next ~12 months, peaking somewhere in the 4.25 – 4.75% range. Cementing this expectation was recent inflation data, which didn’t show a drop in inflation, but rather stabilization at current levels, leaving it far above the fed’s target rate of ~2%.
While a Fed Funds rate of 3-4% doesn’t seem punitive, the pace of increases and signaling for additional hikes, alongside quantitative tightening (which is the process of removing liquidity from financial markets) has had a significant impact on markets globally. While it is tempting to “blame The Fed” for the ~20% drop in the S&P 500 and a ~30% drop in the NASDAQ this year, other significant events globally have contributed, not the least of which is a major war in Europe which accompanied an energy crisis and a Chinese economy still hampered by its “COVID Zero” policy.
It is also important to note that many investors were buying stocks simply because they didn’t have another option as rates were close to zero during the past decade. As rates have accelerated from 0% to ~4%, the hypothesis that “there is no alternative” to stocks is no longer valid. While this is good news for savers and investors long-term, it is a painful transition to experience in real-time.
The Fed is currently between a rock and a hard place, partly due to its own inaction (by not raising rates soon enough in 2021) and extreme fiscal stimulus introduced by both the prior and current administrations. The Fed seems to have two options at this point:
The Fed has clearly picked option 1 (as of September 2022), which has led to sharp interest rate increases for debt ranging from short-term to 30-year mortgages. While unpalatable, The Fed likely considers this to be the best of two terrible options, as going down the second path might make market participants think “The Fed has their backs” again, which could lead to more speculative behavior, higher levels of consumer spending, and initiate an inflation spiral that is nearly impossible to escape.
With that said, I don’t see any reason to keep raising rates beyond the current level in the near-term. Mortgages are already north of 7%, and two-year treasuries are yielding 4.3%! We also have yet to see the economic impact of these higher rates as it takes months for them to truly effect consumer spending and business investments. The Fed should allow these higher rates to work their way through the economy before forcing markets to digest additional increases – too much is on the line to haphazardly keep increasing rates at 0.75% monthly.
I'm also watching the pace of balance sheet reduction by The Fed, which can have a greater impact on mortgage rates than simply increasing their benchmark rate. While reductions started earlier in 2022, they have yet to make a major dent in the $8.8 trillion in total assets. Acceleration here would signal an even tighter monetary position by The Fed in the coming months.
As is the case whether the market is up or down 20%, you need to ensure you have the appropriate asset allocation.
Now that we have that off our plates, we can discuss the current scenario. Markets are down as investors are anticipating a slowdown of some kind from the rampant economic growth experienced in 2021 and due to tightening financial conditions caused by The Fed actions. As markets are forward-looking, they are already down ~20%, while economic activity hasn’t really budged yet. The question is really “Will things be better or worse than anticipated?”
Historically speaking, things always get better. It is not a question of if, but when, and how much more pain (if any) remains. It is highly probable that news of an economic slowdown will become more prevalent, along with pessimistic prognostications in the news. This is always a part of market downturns and the emotions that accompany them.
Keep in mind, the reason you earn a return investing over the long-term is because of the pain endured during periods of negative performance. You cannot have one without the other.
My advice: Focus on the things you can control – which means sticking to your plan, ensuring your investment strategy aligns with your goals, and allowing the market to behave as it does over time - with as little tinkering as possible.
(For more about the Fed’s actual role in the economy and how the Fed Funds Rate ripples through debt markets, please read our previous post here)
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