Stocks rallied again yesterday in a very erratic seesaw session as investors reacted to comments made by Fed Chair Jerome Powell. Bond yields edged higher.
While most of the nation focused on last night’s State of the Union Address, investors were much more attuned to what the Fed said after markets reacted so positively to Powell’s comments after last week’s FOMC meeting. The presumption before he spoke yesterday was that he would strike a hawkish tone trying to ameliorate the enthusiasm in the market. A booming stock market doesn’t make his job of cooling the economy in order to reduce inflationary pressures any easier.
Powell was pragmatic instead. He recognized that inflation was receding. Although he reiterated concern about labor market strength, and said more rate increases might be needed, he concluded that the war was going in his favor. Future FOMC action will continue to be data dependent. Lumping yesterday’s remarks with the post-FOMC meeting press conference, investors have reacted by increasing odds that the Fed would move at least two more times before its job of raising the Fed Funds rate is complete.
While I have noted that I thought rates were high enough already to complete the task, it is pretty clear at the moment that another rate hike in March is likely and that odds today favor yet another increase in May. If I turn back the clock a year, the Fed was way behind the curve. Inflation was out of control as the Fed was just beginning to raise rate. Last February, the Fed was still adding assets to its balance sheet and the money supply was surging. It took almost a full year for the Fed and markets to get on the same page. For a while, it appeared the Fed was more hawkish than the markets. 10-year Treasury rates spike to over 4.25% in October and the 2-year rate exceeded 4.7%.
After October, markets turned less hawkish as signs began to appear that inflation had peaked. Some of the improvement came from healing supply chain disruptions. As more cars appeared on dealer lots, used car prices tumbled. As mortgage rates rose, lumber prices tumbled. As the dollar weakened, so did oil prices. A warm winter helped. Before too long, fears of recession faded and the possibility of a soft landing increased. We have always been on the fence on this question and remain so. Clearly, we are not in a recession today with unemployment at 3.4%, but it is also clear that the impact from all of last year’s rate hikes hasn’t been felt yet. Despite waning orders, homebuilders are still working off huge backlogs. Auto manufacturers are still reloading dealer lots. On the other hand, many retailers now have excess inventories as do certain industrial segments. Recession is still possible, but the timing has been put off until later this year, if it happens at all. Markets have a long history of predicting recessions that never happen.
It is true that the yield curve remains inverted. Every recession has been preceded by an inverted yield curve, but it is also true that curve inversion can happen without a recession. This week Treasury yields all along the curve have risen. 10-year yields, which briefly fell below 3.4% last week, have rebounded by about 25 basis points. Two-year rates rebounded close to 35 basis points from last week’s lows. At the same time, futures markets indicate that the odds of another 25-basis point increase in March is approaching 95% versus 75% pre-FOMC meeting. Markets now favor another increase in May, a 70%+ likelihood, with a third increase a 50-50 proposition in June. Beyond then, it’s pure guesswork, but the scenario I just laid out puts markets and the Fed in almost perfect sync for the first time in well over a year. That’s clearly a positive.
If the Fed and markets are in sync on the pattern of pending hikes, they still disagree when cuts are coming. The market says at least one, maybe two before the end of 2023. Markets, at the same time, are less fearful of recession. My rhetorical question is what incentive is there for the Fed to start reducing rates in absence of a recession? The only answer would be to stimulate growth. But given the tough fight against inflation, why would the Fed want to pivot before it has to, risking a chance that inflation might reignite?
One factor that has helped the fight against inflation has been dollar weakness. As our growth slows, recession or no recession, upward pressure on the dollar wanes. For goods priced in dollars worldwide, like oil and other commodities, that means lower prices. That, of course, helps the Fed in its battle against rising prices. With the Fed and markets now on the same page, bond volatility may slow and the dollar’s slide could become more moderate as well. That makes the inflation battle more difficult supporting the case for more rate increases and staying higher for longer.
In sum, it’s good news that the Fed and markets see the pattern of pending rate increases similarly. But any notion that bond yields will return to 2021 levels anytime soon is foolish optimism.
Equity markets have been celebrating slowing inflation, the pending end to the cycle of rate increases, and increasing odds of a soft landing for months. Momentum has pushed markets to their highest levels since last August, but markets may not be reflecting what lies on the other side. Demographics suggest slower growth than in the past worldwide. With the possibility that the unemployment rate stays low for longer, there will be little incentive for the Fed to cut rates very far. As I have noted previously, between 1965 and 2000, the effective Fed Funds rate was below 3% for exactly one month. Normal is 4.0-5.5%, exactly where we are now. At some point, the Fed will moderate rates a bit, but without recession, the pace of moderation will likely be very slow.
That picture is in distinct contrast with a market selling at 18.5 times 2023 expected earnings. If those earnings expectations fall, 18.5 may be an overstatement. Even allowing for a healthy rebound in 2024, P/E multiples don’t match up compared to a historic norm of 2% real growth, 2% inflation, and a Fed Funds rate of 4.0% or higher. That doesn’t mean that current equity momentum will wane suddenly. There has to be a catalyst for that to happen. More than likely, it would come from future earnings disappointments. Q4 earnings season has hardly been good news. The level of positive surprises has been less than in recent quarters. Overall, earnings will fall for the first time in over two years. There is little reason for optimism over the next two quarters.
Thus, I remain cautious recognizing the power of momentum in the short term. Equity investors are optimistic. They will remain so until something intervenes, but I wouldn’t buy into this rally. Rather I would wait for some kind of correction and then reassess.
Finally, I want to share a brief thought on last night’s State of the Union Address. President Biden broke little new ground. He repeated his laundry list of progressive ideals even repeating some like free community college that have long been dead in the water. A debt ceiling is approaching. There is little reason to believe that both sides won’t stop rattling sabers until the 11th hour. How much animosity remains after the issue is resolved will tell us the possibility of getting anything substantive done before the 2024 election. There are few areas of bipartisan agreement. Mr. Biden clearly looked like he was setting the table for a second term. The Democratic odds of retaining the Senate in 2024 are not good based on who is running for reelection. The House is up for grabs. But, if one party is to control both chambers, it is more likely to be the Republicans. It is way too early to make any judgment on the outcome of the Presidential race.
Today, author John Grisham is 68. Composer and conductor John Williams turns 91.
James M. Meyer, CFA 610-260-2220