By Josef Adinolfi
The pace of Fed rate hikes is often not what investors or the central bank expect
Buy shares now or wait?
The timing of the market has been a nagging question for investors since the stock market began its roughly 25% decline in January of this year. The correct answer likely depends on whether or not the Federal Reserve goes through with its plans to raise its benchmark interest rate to 4.5% or higher next year.
Global markets are nervous about the possibility of an emerging markets crisis due to higher interest rates and a US dollar at a 20-year high, or a housing market slump due to rising mortgage rates, or a financial institution collapsing into its worst bond market in a generation. As a result, questions about the Fed’s ability to follow through on its planned rate hikes to tame inflation without forcing the economy into recession have rattled markets on an almost daily basis.
Assuming the Fed succeeds and turns policy when a financial stability crisis hits, or inflation peaks, or the case for buying stocks remains solid — over the next year or so, according to two market analysts.
The problem is that continued market volatility makes it difficult to determine when markets may present buying opportunities, said Bill Sterling, global strategist at GW&K Investment Management.
The spike in interest rates matters to stocks
Historical market data may give investors good reason to be skeptical about the credibility of Fed forecasts, while market-based expectations captured by Fed fund futures markets and bond yields may not be more reliable.
Since August 1984, the S&P 500 index has risen an average of more than 17% in the 12 months (see chart) following a peak in the Fed’s interest rate range, according to data from Sterling at GW&K and the Fed.
The chart also shows that the Nasdaq Composite COMP and Dow Jones Industrial Average DJIA have risen sharply in the year after the Fed pushed interest rates to their peaks in previous monetary tightening cycles over the past 40 years.
The same is true for bonds, which have a history of outperforming after the Fed’s rate-hiking cycle peaked. Sterling said yields have fallen by an average of a fifth of their value in the 12 months since the Fed benchmark rates peaked.
One factor that still distinguishes the modern era from the sustained inflation of the 1980s is the heightened level of geopolitical and macroeconomic uncertainty. As Tavi Costa, portfolio manager at Crescat Capital said, the ailing US economy and fears that a crisis could erupt somewhere in world markets are complicating the monetary policy outlook.
But as investors monitor markets and economic data, Sterling said “backward-looking” metrics like the US CPI and Personal Consumption Spending Index aren’t nearly as helpful as “forward-looking” indicators like the breakeven spreads generated by inflation-linked government bonds or survey data such as the University of Michigan Inflation Expectations Indicator.
“The market is caught between these forward-looking and encouraging signs that inflation may ease next year, as evidenced by {inflation-linked government bond yields],” Sterling said.
So far this week, Minneapolis Fed President Neel Kashkari and Fed Governor Christopher Waller have said that the Fed has no intention of abandoning its rate hike plan, in what was just the latest round of aggressive comments from senior Federal Reserve officials .
However, some on Wall Street are paying less attention to the Fed and more to market-based indicators such as Treasury spreads, relative movements in government bond yields and credit default spreads, including those from Credit Suisse Inc. (CSGN.EB).
Crescat Capital’s Costa said he sees a growing “disconnection” between the state of markets and the Fed’s aggressive rhetoric, with the likelihood of a crash increasing by the day and therefore waiting for “the other shoe to fall.”
He reckons a blast will finally force the Fed and other global central banks to scale back their monetary tightening agenda, as the Bank of England did last month when it decided to inject billions of dollars in liquidity into the gilts market to squirt.
See: Bank of England official says $1 trillion in pension fund investments could be wiped out without intervention
Tavi expects fixed income trading to become as disordered as it was in spring 2020, when the Fed was forced to step in to avert a bond market collapse early in the coronavirus pandemic.
“Just look at the difference between government bond yields versus junk bond yields. We haven’t seen this spike driven by default risk, which is a sign of a totally dysfunctional market,” Tavi said.
See: Cracks in financial markets fuel debate over whether next crisis is inevitable
A simple glance in the rearview mirror shows that the Fed’s rate-hike plans rarely work out as the central bank expects. Take last year for example.
The median forecast for the level of Fed interest rates in September 2021 was just 30 basis points a year ago, according to the Fed’s Survey of Projections. He was off by almost three whole percentage points.
“Don’t take the Federal Reserve’s word for it when trying to predict the direction of Fed policy next year,” Sterling said.
Looking forward to next week
Looking ahead next week, investors will get a little more insight into the state of the US economy and, by extension, the Fed’s mindset.
US inflation data will be the focus of markets next week, with September CPI due on Thursday. On Friday, investors will get an update from the University of Michigan’s Consumer Sentiment Survey and its Inflation Expectations Survey.
Additionally, for the first time in months, investors are grappling with signs that the labor market may actually be weakening, according to Krishna Guha and Peter Williams, two US economists at Evercore ISI.
Friday’s jobs report showed the US economy added 263,000 jobs last month, with the unemployment rate falling to 3.55-3.7%, but job growth slowed from 537,000 in July and 315,000 in August.
But will inflation show signs of peaking or slowing? Many fear that cuts in crude oil production quotas imposed by OPEC+ earlier this week could push prices higher later in the year.
Meanwhile, the Fed fund futures market, which allows investors to place bets on the pace of Fed rate hikes, expects another 75 basis point rate hike on Nov. 3.
Additionally, according to the Fed’s FedWatch tool, traders expect the Fed’s interest rate to peak at 4.75% in February or March.
However, should there be a monetary policy “pivot” from the Fed, investors should expect stocks to soar in the fourth quarter. Ultimately, trying to predict when interest rates will actually peak could be a way for investors to get rich by challenging the consensus.
The Nasdaq fell 3.8% on Friday, trimming its week-to-date gain to just 0.7% as it ended the session at 10,652.40. Meanwhile, the Dow Jones Industrial Average fell 2.1% on Friday, trimming its weekly gain to just 2% as it ended Friday’s session at 29,296.79.
-Joseph Adinolfi
(ENDS) Dow Jones Newswires
10-08-22 0830ET
Copyright (c) 2022 Dow Jones & Company, Inc.
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