The decision to skip in June was the first pause since the Fed began its hiking campaign 15 months ago. Investors were initially disappointed by the Fed’s statement which suggested interest rates are not yet “sufficiently restrictive” while they raised the median fed funds rate forecast to 5.6% from its current 5.1% which implies two more 0.25% rate hikes. Investors remain skeptical.
Bond traders are increasing their bets that a recession is coming. The difference between 2 and 10-year US Treasury yields is inverted by almost -1% now (see chart below) which is approaching the low of -1.1% reached in March of this year. Most current economic data is suggesting that the economy is slowing. For example, M2 money supply is negative, commodities prices and freight rates are down, layoff announcements have increased, etc. Yet the Fed continues to increase the fed funds rate target.
So, what is going on? It seems to us like the Fed is using hawkish language and rising interest rate forecasts to stop the bond market from pricing in future interest rate cuts. The Fed needs tight financial conditions to slow the economy and achieve the targeted decline in the inflation rate. Yet when the bond market prices in future rate cuts, this counteracts the Fed’s actions and makes achieving the 2% inflation target even more difficult. So, is the Fed bluffing or not? This is the real question investors are asking. The problem for the Fed is that its preferred measurement of inflation, the personal consumption expenditure price index (“PCE”), has been stubbornly flat during the past year, hovering between 4.6% and 5.2% (see chart below). This is more than 2x the Fed’s long-term target. Thus, the Fed wants to see an actual decline in the PCE before signaling that it is finished hiking rates. But investors see the tidal wave of weakening economic data, which is the result of the lagged effects of prior rate increases. This is an epic struggle for the Fed, but it must remain steadfast or else lose its greatest asset – credibility.
Meanwhile, Chairman Powell noted during his press conference that “…the full effects of our tightening have yet to be felt”. The Fed may be making the same mistake, but in reverse, that it made by holding rates at zero for too long during the pandemic years. There are mixed signals for sure.
The S&P 500 is now up roughly 15% YTD. Interestingly, certain sectors like financials and energy are trading near record low PEs, while technology and industries like homebuilding are trading near peak valuation levels. And, in fact, some of the worst performing stocks in 2022 have become the best performing in 2023 (e.g. Tesla). All this while market volatility measures like the VIX are near record lows. This may be a perfect market for contrarians!
This is truly a time of great economic uncertainty. Will the market’s next move be +10% or -10%? We just don’t know. It is not a question that can be repeatedly answered correctly with a strong degree of confidence by anyone that is honest. But as Warren Buffet notes, uncertainty creates opportunity. If you can ignore the day-to-day noise of market prognosticators and economic data releases that cause daily market gyrations, you can find some great companies at attractive valuations during times like these. So, whether the Fed raises 0, 1 or 2 more times simply doesn’t matter in the long run. Let’s keep calm and carry on with our mission of finding great companies at attractive valuations.
Today boxer Roberto (no mas!) Duran turns 72. Author Joyce Carol Oates is 85, and Artist Jim Dine turns 88. For you baseball trivia people, Kerry Wood turns 46 today. The former Chicago Cubs pitcher is the co-holder of the record for most strikeouts in a game with 20!
Christopher E Gildea
610-260-2235