All Eyes Remain on the Fed
By Cory McPherson | November 2022
A lot of the pain in stock and bond markets this year can be traced back to the Federal Reserve with their interest rate increases and quantitative tightening program.
The chart above shows the pace of interest rate increases this year is far greater than at any time period before. This doesn’t even factor in the most recent increase happening this week of another 0.75%, bringing the Federal Funds rate to 3.75%-4.00%. As we’ve pointed out in previous newsletters, the Fed typically doesn’t stop raising rates until something breaks in the economy or markets. With the Fed removing liquidity from the markets at the most aggressive pace ever recorded, the risk to the market is higher than most people appreciate. While we’ve seen a large drawdown in stock and bond markets already, we haven’t necessarily seen anything “break”, and certainly not a crash type event.
It's quite possible the Fed has already tightened more than the economy can withstand. Much of the interest rate hikes don’t get felt in the financial system and economy for many months down the road. Most estimates are that it takes 9-12 months for rate hikes to be felt, and 12-18 months for the maximum effect. Currently we’re just 8 months past the first rate hike, that started at just 0.25%. As rates go up, borrowing costs go up for consumers and for businesses, leading to less economic activity. While the labor market appears strong and unemployment remains low, as rate increases ripple through the economy that picture may begin to change.
Treasury Yields
A look at the treasury yield curve shows trouble ahead for the economy. The rate hikes from the Fed have caused the short-term rates to spike this year at a much faster pace than the longer-term rates. The shorter end of the curve historically has been much more tied to Fed policy. The longer end of the curve historically is more tied to economic conditions and inflation. Overall, you should obviously be getting paid more in interest the longer the duration of the Treasury bond as you take on more risk with the longer time period. When you get an inversion (short-term rates higher then long-term rates), an economic recession has typically been imminent. It signals investors expect higher short-term rates, but are growing nervous about the Fed’s ability to control inflation without hurting economic growth.
Some economists like to look at the 10-year versus the 2-year yield spread. Some prefer the 10-year versus the 1-year, and most like to follow the 3-month versus the 10-year. Problem is, they are all inverted currently. The chart below shows the spread between the 10-year rate (4.07%) and the 3-month rate (4.23%) turning negative recently, and how it has preceded previous recessions (shaded areas).
The inversion of the 2-year and 10-year spread happened early in the summer and is reaching levels not seen since the 1980’s, with the 2-year rate at 4.54%, and a spread of -0.47% compared to the 10-year rate.
Keeping an eye on the bond market, and Treasury yields can give clues as to what direction the stock market and the economy overall could be headed.
An October Rally
Despite the Fed being expected to continue its interest rate increases at their November 2nd meeting, the stock market had a sizeable rally in October.
After a big reversal day occurring on October 13th, the S&P 500 has rallied up to near 3900, marking a short-term bottom on the index at 3491. We did have a short-term indicator turn positive in October, leading us to make some small moves in some portfolios to take advantage of the rally and remove our hedges.
We believe 3900 on the S&P is an important area for the market. It has served as both support and resistance for the past few months. A sustained bounce above that level leads to a continuation of this rally and another attempt at getting above it’s 200-day moving average (red line in the chart above). You can see the red line is where the market rally over the summer failed in mid-August. If 3900 cannot be overtaken, any drop below the 20-day moving average (green line) around 3780 would be seen as a resumption of the bear market, and a re-test of the lows from October likely.
While we have become a bit more positive in the short-term, the intermediate to long-term picture remains murky at best to us. In the short-term, we have entered into a period for the stock market that has historically produced the best gains, from the end of October through the end of the calendar year. This could help in boosting this rally into year-end.
Investor sentiment can also be a short-term driver of markets going higher. The chart below shows how investor sentiment has not been this low in the last decade, and only matched by previous bear markets. Markets typically do the opposite of what everyone is thinking, and if everyone is pessimistic on the market, a sharp reflexive rally can occur.
Much of this rally has also been driven on hopes of a possible slowdown in interest rate hikes from the Fed, or a “pause”. The Fed has not signaled that to be the case though. It has created an odd time in the market, as bad economic news has become good news for the market, and vice versa with good economic news being bad news for the market. Bad economic news gets interpreted as the Fed could end their interest hikes sooners than expected with the economy weakening. While good economic news means the Fed could continue on their path of higher rates.
We are also wary of typical bear market rallies, that can cause great amounts of pain and fool investors into getting back in too early. The chart below shows the different rallies that occurred during the last bear market from 2007 to 2009.
The average bear market rally since the 1950’s lasts roughly a month and results in an average 15% rise. Nevertheless, in each case, the overall market trend remains down. This is simply a fact of life in bear markets.
It has never been a good idea to fight the Fed when it enacts measures to control inflation. Clearly, our indicators are not confirming the return of a bull market in the near term. We view the current strong retracement move as a typical bear market rally and an opportunity to temporarily improve our market position, but it’s not likely that we have seen the last of this bear market.
This is hardly the environment desired by the Fed to quell inflation. Investors hoping for a return to bullish markets should be aware the Fed is ultimately pushing for lower stock prices.
For now, investors remain at the mercy of volatile markets. Gold has not been the inflation hedge or market hedge many tout it to be. Bonds have not hedged against stock market risk. And stocks remain under continuous pressure. One benefit of rising interest rates, money markets and CDs have provided a place where capital can find safety with higher rates of interest. While we hold more cash we are getting paid more interest to do it. We also can purchase CDs for clients through Charles Schwab, and if you’re interested in comparing rates to what you might get at a local bank let us know.
In Conclusion
The historic pace of Fed interest rate hikes this year continue to dampen markets. While there is room for a reflexive rally in the short-term, we believe this bear market has longer to play out.
Over the next 6-9 months the effects of the spike in interest rates should begin to weigh on the economy, and further hikes are expected. Higher borrowing costs and prices will ultimately start to force consumers to choose to spend less thereby slowing economic growth. Corporations will be paying more in interest costs to service their debt.
If concerted fed efforts, consumer pessimism and inflationary conditions continue to prevail in the fourth quarter, these factors may ultimately drive the economy into a recession and further market declines.
We have learned that it is a bad idea to try to fight the Fed.
New Contribution Limits for 2023
On October 21st, the IRS announced new contribution limits for retirement accounts. These include:
IRA/Roth IRA: $6,500 ($1,000 catch up for over age 50)
401k/403b: $22,500 ($7,500 catch up for over age 50)
Simple IRA: $15,500 ($3,500 catch up for over age 50)
Contact us on any questions with contributions to your retirement accounts.
An announcement was also made in October that Social Security recipients will receive an increase in their benefit of 8.7% in 2023. With it being tied to the consumer price index (CPI), that is at least one benefit to higher inflation.
Reminder
If you know of someone that would like a second opinion on their portfolio, or needing help with financial planning, please don’t hesitate to give them our info. We would be glad to see if we can be of service. Client referrals continue to be the life blood of our business and we are grateful for the many referrals we have received this year from you all. This type of market environment has led many to seek a second opinion.
Also remember that our services extend well beyond portfolio management. We are experienced at reviewing social security, Medicare, employee benefits, and estate planning matters as well as discussing or providing second opinions regarding insurance products such as life insurance, long term care, and annuities with our clients.
As always, feel free to contact our office via phone or email with questions at any time.
Cory McPherson is a financial planner and advisor, and President and CEO for ProActive Capital Management, Inc. He is a graduate of Kansas State University with a Bachelor of Science in Business Finance. Cory received his Retirement Income Certified Professional (RICP®) designation from The American College of Financial Services in 2017.
Disclosure