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The Download: 1Q 2023

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Fed funds rate - higher for longer?

Growing up in the 1980s, our generation was awarded a particular level of freedom.  Looking back, it seems we were the last truly free kids. We did not have cell phones, we played outside all day every day, and there were even TV commercials that asked, “It’s 10 PM; do you know where your kids are?”.  We were also free from information overload.

Before the internet, we were all relatively innocent of information. There was no 24-hour news cycle, no social media, only limited access to research or data, and our phones had long and tangled cords. Information was delivered through the nightly news, a magazine or two, and the local newspaper. In retrospect, we probably didn’t have a clue what was going on. In fact, I can still remember seeing my first fax machine. Until then, business was conducted in person, through the mail, or over the phone, under conditions of almost no information. How did we all survive? Yet, we flourished. The 80s and 90s were a time of prosperity and one of the best 20 years in history to be an investor.

Today, the culture of news couldn’t be any different. Due to the endless sources of delivering information and the competition for your eyeballs, most news—if not all—is bad news. And it never stops—all day, every day, from every direction.

The constant drumbeat of anxiety-provoking news, research, and articles over the past year would lead an investor to believe that a recession is inevitable and that the stock market simply must collapse.

I am here to report the good news. The economy remains resilient, and the stock market is up. Unemployment is near record lows, wage growth near record highs, and consumer and business spending remains above expectations. Business performance, too, continues to surprise pontificators. Despite the obvious earnings headwinds of higher costs and higher interest rates, business revenue growth and capital expenditures remain strong. Furthermore, so far, it appears that the banking crisis is contained to only a few names, that loan defaults don’t appear to be an issue, and that the housing market remains in short supply.

I know…that was painful to listen to all that flaky good news.

To grab your attention back, though, I am happy to report that there is something to worry about. It is likely that inflation and interest rates can stay higher for longer and that the higher interest rates are only now beginning to impact the economy.

Inflation and the Fed – higher for longer

First, the good news. Inflation appears to have broken the fever. Since July 2022, there has been a remarkable change in the level of inflation. If one were to average the inflation rate since mid-2022, it would imply that we are on about a 3.5% annual inflation run rate. While this is not down to the Fed goal of 2% or the levels of the ‘Slow and Low” decade, the current inflation rate is much lower than that of the COVID shortages era.

Data as of March 31, 2023. Source: Federal Reserve Bank of Cleveland. https://www.clevelandfed.org/indicators-and-data/inflation-nowcasting

Historically, once the Fed Funds Rate exceeds the inflation rate, this signals that the Fed is nearing the end of its tightening campaign.  Today, it appears that this is the case. The simple 12-month inflation rate is currently 5% for the CPI-U. The current Fed Funds Rate is guided at 4.75-5%. While it appears that inflation and the Fed Funds Rate have met at 5%, the current run rate of inflation is closer to the mid-3% range. This implies the Fed Funds Rate is squarely above the current inflation rate.

However, it is possible that the Fed still has a couple of more rate hikes in them. It is also likely that inflation will remain above the Fed target of 2% for quite some time. This would imply that the Fed won’t be easing rates anytime soon. At this point, it appears that the Fed Funds Rate is likely to remain higher for longer.

The economy and business performance

It is well understood that interest rates have a lagged relationship to the economy. It takes about a year for businesses and consumers to truly feel the cost of higher interest rates. Well, we are likely approaching that time.

While earnings estimates for stocks have come down considerably since the Fed started raising interest rates, it is only now that earnings are starting to be impacted. The consumer has been remarkably strong through this cycle, but she, too, will begin to feel the impact of higher interest rates. Further, a higher for longer Fed Funds rate can also lead to large-scale imbalances like banking stress, debt issues, or a real estate debacle.

All figures as of December 31, 2022, unless otherwise stated. Source: FactSet. Past performance is no guarantee of future returns.

An unpriced risk here is that if interest rates remain higher for longer, businesses and consumers may feel this pressure for longer than anticipated. Secondly, and most evident last quarter, is the impact of higher for longer on the banking system. Disintermediation is when savers move their money out of low-yielding savings accounts into higher-yielding money market-type accounts or general investment accounts. This force drains money from banks. If banks don’t have savings, they will have a hard time lending. To compound this issue, an inverted yield curve is also restricting lending. If banks restrict lending, the economy will contract.

Higher Fed Funds Rate and the bond market

The most nuanced impact of a higher for longer Fed Funds Rate is an inverted yield curve. Normally, the longer the duration of a bond, the higher the yield that the investor receives. Rarely though, when the Fed is too tight, and the bond market expects a recession, the yield curve becomes inverted. This happens because bond investors drive the yields of future-dated bonds down to where they think the Fed Funds Rate should be. Thus, longer-dated bonds end up yielding less than shorter-dated bonds.

INVERTED YIELD CURVE – AS OF MARCH 31, 2023

Data as of March 31, 2023. Source: Bloomberg.

There are several problems with this rare and short-lived phenomenon. The first and most important is that, again, lenders will restrict lending. If a bank or lender has to borrow money today at 5% and then lend it out long-term at a rate below 5%, they simply can’t make any money. And you can’t make that up on volume.

Secondly, the inverted yield curve implies that the returns of longer-dated bonds may face return headwinds. For the yield curve to return to its normal upward-sloping state, one of two things must occur. The Fed needs to lower the Fed Funds Rate, or the yields on longer-dated bonds need to rise. It doesn’t appear that the Fed is likely to cut rates anytime soon. Thus, the yield curve could stay inverted longer – which could restrict lending and be prohibitive for banks – or longer-dated yields could rise. The most favorable way out of this situation would be for the Fed to cut rates or at least pause rate hikes.

The takeaways

It feels as if we are on a very predictable path here. The Fed started raising interest rates about one year ago, and we are now beginning to feel the effects of this.

A higher for longer Fed Funds Rate presents distinct challenges for the economy, businesses, and capital markets to deal with:

  1. While inflation is abating, it will likely remain above the Fed’s long-term target of 2%. The Fed appears to be near the end of its tightening cycle, but they are unlikely to lower the Fed Funds Rate anytime soon.
  2. While business performance and consumer spending have been surprisingly strong, it is likely that higher interest rates and restricted lending are now starting to take effect.
  3. A high Fed Funds Rate is causing imbalances in the bond market in the form of an inverted yield curve.
  4. The inverted yield curve has uncovered potential bond positioning opportunities for yield-seeking investors but also presents challenges for strategic holders of core aggregate bonds.

While this sounds like your run-of-the-mill bad news, this shouldn’t be new or surprising news. By now, this feels like the most anticipated slowdown in history. Thankfully dull and well-accepted bad news often loses its ability to impact capital markets. That is because capital markets lead the economy and have likely already priced and accounted for widely accepted risks. What we are left with is surprises. Surprises, pleasant or worse than expected, move capital markets off their natural trajectories. And not all news has to be bad news. If the tone of the marketplace is a cloud of negativity, maybe pleasant surprises are the new unpriced risks.

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ASSET CLASS INDEX INDEX DESCRIPTION
U.S. Large Cap Equity S&P 500 Represents US large company stocks.

 

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