The Rate Hikes Will Continue…
Legend is that Lieutenant William Bligh was a strict disciplinarian aboard the Royal Naval vessel HMS Bounty. Despite there being no known written record of it, the statement “The beatings will continue until morale improves” is often attributed to Lt. Bligh during his tenure as the ship’s captain. The crew of the Bounty eventually became fed up and staged a mutiny April of 1798, seizing control of the ship from Lt. Bligh, sending him and eighteen loyalists adrift in the South Pacific. The Federal Reserve seems to be on a similar steadfast path of raising interest rates until inflation subsides. But with cracks appearing in the financial system the markets seem to be staging their own mutiny.
The Fed raised its target interest rate by a quarter percentage point last Wednesday, continuing its campaign to fight inflation, which remains persistent and above the Fed’s proclaimed comfort zone. Comments from Fed officials after the meeting also signaled that at least one more rate hike may be in store. They also stated their current assumption is that other tools, such as emergency lending and deposit guarantees, will contain damage among U.S. banks. It is quite possible stress from banks and the recent tightening of lending standards will curb economic activity, helping counter inflation and taking some of the pressure off the Fed to continue raising interest rates.
Interest rates have continued their wild ride with longer term rates continuing to drop from recent highs, indicating markets expect economic activity to slow and the Fed to lower rates faster than previously thought. The inversion between 2-year and 10-year Treasury bond yields continues to narrow. Such inversions do not guarantee a recession but have been accurate predictors in the past, generally about 9-12 months in advance. An upcoming recession has been widely predicted by many economists, perhaps the most anticipated recession in history. But it should be noted that the difference in yields tends to climb back above zero just before recessions begin, so one may be on the near horizon if this pattern repeats itself.
Navigating the Rough Seas
In the face of volatility, equity markets finished last week higher with the S&P 500 and Nasdaq both posting gains for the second consecutive week, overcoming global banking turmoil which continues to weigh on financial stocks. Technology stocks have been the strongest performers as of late with the Nasdaq now higher by 13% on the year. The financial sector continues to languish as major European banks have found themselves in trouble, pressuring stocks of foreign and domestic institutions. Last week’s volatility was marked by the buyout (rescue) of Credit Suisse, pushing stocks higher, but they dropped mid-week on the heels of comments from Fed Chair Powell that the Fed plans to continue raising short-term rates, coupled with a statement from Treasury Secretary Janet Yellen that blanket deposit insurance is not something currently being considered. Stocks overcame concerns about the health of Deutsche Bank and the possibility of contagion spreading to life insurance companies on Friday to rebound and end the week on a positive note.
Materials stocks and commodities are experiencing headwinds amid global recession fears and reduced demand but supplies of raw materials are tightening. If a recession is avoided or supplies are further constrained there could be a sharp snap-back in commodities prices. Throughout the recent financial upheaval, gold and Treasury bonds have been safe havens. This behavior is reminiscent of asset price action during periods of market turmoil in the past, more so than what we experienced in 2022 when stocks, bonds, and precious metals all lost value. Corporate bonds, especially non-investment grade or high-yield, have also come under pressure recently since a large majority of that market is comprised of financial firms. Spreads, or the difference in yields between corporate and treasury bonds of similar maturities, have been widening; an indication that investors are requiring greater compensation for the additional risk. However, spreads are not yet near what would be considered levels of stress, but this is something to watch in coming weeks.
Attention will remain focused on the financial sector, with any major news likely to drive markets. There have been reports and data showing a significant amount of deposits being moved from smaller banks into larger banks but that seems to have subsided, at least temporarily. A great deal of money has also been moved into money market funds for safety. This money can easily be invested in the market so if (when) we see a stock rebound it could quickly accelerate as there is plenty of money waiting on the sidelines. The Fed’s preferred inflation gauge, the Personal Consumption Indicator (PCE) deflator will be released this coming week but since the Fed does not meet again until May this particular report may have limited importance with many other data points being released throughout April. Market catalysts in April are likely to shift away from the Fed and toward first quarter earnings reports, barring any major events in the financial sector.
At odds with signals from Fed officials that they plan to continue raising interest rates, the Fed Funds futures market is signaling the Fed is done raising rates and, in fact, not only currently predict the Fed will pivot and begin to lower rates in June but also rates will be lower by at least a full percentage point by the end of the year. Over the past 25 years there have been three completed hiking cycles; when the current cycle eventually ends it will be the fourth. During the three previous cycles rates were held at their terminal rate for a minimum of 7 months. Even if we are at the top of the current interest rate hiking cycle, history tells us the Fed probably will not drop rates until at least late in the year, if not 2024. If they do indeed begin to lower rates in the next few months it would be because of something “breaking,” which now seems to be the banks. That is not a good scenario for stocks. A much more favorable scenario would be if the Fed does not have to do a quick pivot, though higher rates could weigh on growth stocks such as technology since their prices are predicated upon future cash flows which have a lower present value when interest rates are higher.
If you are stressed about the current market environment, contact us if you would like to learn about strategies to protect your portfolio while not missing out on the possibility of a market rebound. Avoid having a mutiny wreak havoc on your retirement plans.
Have a wonderful week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
Please contact us if you would like to review your individual financial plan or learn how the TaxSmart™ Retirement Program can help you.
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