Stocks continue to fall as interest rates continue to rise. Short-term rate increases are a direct result of the Federal Reserve’s policy to steadily raise the Fed Funds rate. Another increase of 50-75 basis points is expected in two weeks. At least 50 basis points are already priced into sub-one year Treasury issues. Longer-term bond yields are more tied to other factors including long-term inflation forecasts and policies designed to reduce the size of the Federal Reserve balance sheet. As of the start of September, stated policy suggests that the Fed will reduce its balance sheet, largely by letting assets roll off as they mature, by $95 billion per month. That is double the pace prior to September 1. In less than two weeks, since Jerome Powell’s hawkish speech at Jackson Hole, the yield on 10-year Treasuries has risen by more than half a percentage point. That move alone directly accounts for close to 200 points or roughly a 5% move down in the S&P 500 average.
At first glance, a tougher stance against inflation and tighter monetary policy might appear to be a precursor to lower long-term rates. After all, policy is designed to lower inflation and slow the pace of economic growth. Slower growth normally is a negative influence on stock prices. In weak times, investors normally drift towards havens of safety. What is safer than Treasury bonds? More demand for Treasuries would push yields down, not up. So would lower inflation expectations, but those influences may be offset by the reduction in the size of the Fed’s balance sheet. $95 billion per month isn’t a huge amount compared to total debt outstanding, which is quickly approaching $30 trillion, but assuming the pace continues, it can have an outsized impact. In addition, high tax receipts and the cessation of Covid-related handouts lowered the Treasury’s need to borrow. Soon that will start to reverse, adding more supply and pushing rates higher.
As short-term rates rise, those with bank deposits are moving money to money-market funds and other instruments that pay more than the few basis points they get on deposits. When money-market funds were paying next to nothing, that didn’t matter. Banks will respond by increasing rates they pay on CDs and savings accounts, but the outflow is likely to continue. At some point, the outflow could impact bank liquidity. We saw that not long ago when reverse repo rates went haywire, requiring the Treasury to step in and take emergency measures to fill the market’s liquidity needs. While it would be nice to think that experience will be a lesson to prevent another liquidity crisis, the odds are significant that it will be the next crisis that forces action. One likely action, should that occur, is that the pace of balance sheet rolloff will decline or cease altogether until markets are satisfied that liquidity is restored.
Prior to the Jackson Hole speech, market consensus was that the Fed would complete its cycle of rate increases by early 2023 and begin to cut rates around mid-year. After Powell’s remarks markets changed course. The message was that any rate cuts at all in 2023 were unlikely. The yield curve quickly flattened, and the consensus forecast for a possible recession rose from sub-50% to significantly higher.
Mr. Powell didn’t say anything new at Jackson Hole, he just said what he had said before more forcefully. Economically, little changed other than stock and bond prices. Subsequent data supports the belief that inflationary pressures are easing. In fact, they are easing rather quickly. July’s CPI showed no increase on the top line and a below consensus increase in the core rate. Last week’s employment report also gave markets good news. The pace of employment growth slowed, and wage increases moderated. Commodity prices have also continued to fall. Gasoline is now below $4 in most markets and falling daily. Food commodities are falling. So are freight rates. Policy is working.
But it isn’t working everywhere. We are still seeing daily reports of shortages of teachers, nurses, police, border patrol workers, judges, and even librarians. Many of these jobs are high pressure positions. The pressure has only increased since Covid-19 and the extreme polarization of our economy. When I was a young kid, a nursery school jingle asked, “What do you want to be when you grow up?”. The answers, also in jingle reply were policeman, fireman, doctor, or teacher. Those were the noble professions we aspired to. A lot has changed over the decades. A Fed-created recession isn’t going to create any more teachers, pilots, air traffic controllers or policemen. All these jobs require months or years of training. While our government was funding safety nets, it was deferring expenses to process immigration, tax audits, passports, or border patrols. These are not problems the Fed is going to solve, but they are problems that overlay the economy.
That leads me to what I believe is the big question for investors. When the economy is still adding 300,000-500,000 jobs every month, it is easy for Fed officials to opine that it will keep rates high for longer. But let’s look forward 6-9 months to next Spring. What if the economy is then losing 100,000 jobs every month while GDP is in decline? Inflation won’t be back to 2%, but it will be moving in that direction. Can the Fed then say it is going to stay with tight money? And if so, for how long? The Fed has two mandates, stable prices, and full employment. By next Spring, given current policy, prices will be moving back toward stable while employment may be moving away from full.
Investors must factor in what is likely to happen, not what officials tell you is going to happen. The Fed has had a tough road to travel since the Great Recession, compounded by a severe Covid disruption. Fed speak since last year has worked to raise rates and slow both the economy and inflation. Kudos for that, but let’s not take today’s tough talk too literally. Mr. Powell says, above all else, that future market actions will be data dependent. Nothing is more important in American economics than the unemployment rate. Rising unemployment conjures up the notion of bread lines from the Great Depression, or mass foreclosures from the Great Recession. If sometime next year our economy starts to lose jobs at an accelerated pace, you can be assured that the Fed will reverse course.
Markets, in a space of less than two weeks, went from overly optimistic to overly pessimistic. The truth lies somewhere in between. Markets may still retest the June lows, or they may set new lows. I can’t outguess what markets will do. When I see two strong days back-to-back, I will listen. But let’s all remember one key point. This economic slowdown was manufactured by the Fed. It was done to slow inflation. The Fed created it. The Fed can stop it. Stopping too soon risks allowing inflation to rekindle, but stopping too late has its own baggage and it can be messy. I suspect that close to year end the rate increases will stop. I think liquidity concerns will stop the Fed’s plan to reduce the size of its balance sheet before it plans to. Markets will anticipate both before they happen. That’s why I continue to believe markets will bottom before the end of October.
Today, comedienne Leslie Jones is 55. Gloria Gaynor is 79. One hit song but we all know it. Columnist and commentator Peggy Noonan is 72.
James M. Meyer, CFA 610-260-2220