Federal Reserve Bank interest rate policy continued to meaningfully impact the U.S. equities markets. While the Fed elected not to raise rates at last month’s meeting, Fed Chair Jerome Powell said he expected interest rates to remain “higher for longer.”
Since the September Fed meeting, intermediate and longer-term rates have risen nearly ½ of 1%, and the stock market—with the benchmark S&P 500 down nearly 5% for September but still up 13% on the year—has given back roughly 30% of its gain. The yield curve remains inverted, with short-term rates still significantly higher than longer term. The aggressiveness of Fed tightening from the record low rates of 2020 has resulted in several anomalies:
- The Bloomberg Aggregate Bond Index, widely used as a fixed income benchmark, is on track for a third consecutive year of negative returns. This is unprecedented in the index’s history.
- The losses incurred by long-term lenders have been staggering. Since the interest rate lows of August 2020, owners of 10-year or 30-year Treasury bonds have lost over 40% and 50% of their capital respectively.
- Two of the top twenty commercial banks in the U.S. failed earlier this year, largely the result of lending long at low rates and borrowing short at higher rates.
For the first time since the 2008 financial crisis, bond yields near 5% represent a very reasonable alternative on a risk/reward basis to stocks. Thus far the Fed has walked a financial tightrope, raising rates enough to reduce inflation but not so much as to cause a recession.
We believe the magnitude of the interest rate increases over the past eighteen months will ultimately cause a recession. Banks have tightened lending criteria, and consumer spending is holding up only by the record use of credit—for the first time ever credit card debt has exceeded $1 trillion. Moreover, the U.S. 30-year fixed-rate mortgage has reached its highest level in over 20 years, adversely impacting home affordability across the country.
The Fed’s balance sheet liabilities have also decreased by roughly $1 trillion, and the Federal Government budget for the year projects more than a trillion-dollar deficit. These deficits have sopped up much of the excess liquidity created to address the pandemic’s impact on the economy. Fiscal measures taken during the pandemic, such as relief on paying back student loans, are now being reversed.
Recent reports, particularly related to job creation, signal that the U.S. economy remains healthy, and lead many market strategists to conclude that the Fed will continue to err on raising rates further. We expect to see more data signaling a slowing economy. In this environment, we are emphasizing high quality, liquid stocks with stable operating results. With war breaking out in the Middle East we anticipate increased financial global market volatility, and we will stay appropriately cautious.
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