“Street cred” is a slang term used to express acceptance and credibility (or “cred” for short) amongst the general public, most often used in reference to young people in an urban environment. CNBC uses the word play to provide short biographies for their guests, with the “Street” referring to Wall Street. Gaining credibility amongst your peers and the general public takes time and can be lost quickly. The Federal Reserve had been losing credibility by not taking enough action to combat inflation, the likes of which we have not experienced in over 40 years.
This began to change this week when the Federal Reserve, more precisely the Federal Reserve Open Market Committee (FOMC or commonly referred to as “The Fed”), raised the Fed Funds target rate by three-quarters of one percent (0.75%), the first time they have raised rates by that amount since 1994. The move was somewhat surprising since the previous week members of the FOMC had indicated they planned to raise rates by one-half of a percent (0.50%). After the hotter than expected Consumer Price Index (CPI) report and University of Michigan Consumer Sentiment Survey showing consumers were very concerned about inflation the Fed decided to up the ante and raise rates even more. The decision to pivot at the last minute to a more aggressive rate hike underscores the general concern that inflation is worse that policymakers had anticipated, but the move helped restore confidence the Fed will do what is necessary to combat inflation, even if it means causing a recession.
Acting quickly to rein in inflation may cause a faster economic slowdown since tighter monetary policy, in the form of higher interest rates, reduces the likelihood businesses and consumers will borrow money to make purchases since the cost to borrow is greater. We see this in the housing market where the national average for a 30-year fixed mortgage is now 5.78%, compared to 2.93% one year ago. This difference in interest rates raises the monthly mortgage payment by 30-40% for an average priced home in most markets, making home purchases less affordable for many buyers, especially since incomes have not kept pace over the same time.
The Fed is now projecting short-term rates to be 3.5% by year-end; an increase of 1.5% since projections were last released in April. With the latest Fed move taking the federal funds target range to 1.5% – 1.75%, the latest projections show rates hikes totaling nearly 2% are now expected between now and the end of the year. Even if inflation falls from current levels of more than 8%, the Fed will need to continue to raise rates in future years until inflation is within their 2-3% target. The Fed expects GDP growth to be only 1.7% each of the next two years and is projecting unemployment to rise as a result of slowing economic growth. Slightly higher unemployment should reduce some of the wage pressures which are currently contributing to inflation but many other inflationary pressures exist, including high energy prices.
Dancing in the Streets
The reaction to the Fed’s actions did not give investors reason to dance in the streets with markets, both stock and bond, whipsawing last week. Initially stocks moved higher after the Fed announcement and Fed Chairman’s Powell’s post-meeting comments where he stated the Fed is not trying to deliberately cause a recession and they do not see a broader slowdown in the economy. The gains quickly turned to rather large losses on Thursday after there was a broader assessment of the economic conditions and signs of a slowdown. Central banks around the world also raised interest rates, including Switzerland who had not previously raised rates in over 15 years, placing further pressure on global equities.
The bond markets also reacted in dramatic fashion. After a sharp run-up in yields leading up to the Fed meetings, with the U.S 10-year Treasury yield reaching 3.48% its highest level since April 2011, interest rates pulled back about 0.25% across most maturities. At one point last week the yield curve “inverted” with 2-year Treasuries yielding more than 10-year Treasuries. Historically a prolonged yield curve inversion has been an early signal of an impending recession, but last week’s inversion was very brief. The yield curve remains fairly flat, and perhaps “humped” with 3-year and 5-year Treasury yields higher than 10-year and 30-year Treasury yields, implying economic uncertainty and fears of a slowdown.
Despite a very difficult stock market and economic challenges that lie ahead, there are reasons for optimism. Inflows into equity funds remain robust and are expected to continue in earnest with the end of the quarter on the short horizon. Many companies across various industries highlighted continued demand during comments made over the past week. Depending upon which metrics you follow, certain pockets of the market are now considered to be oversold and have the potential for a bounce, even if it is short-term.
The Fed has indicated that another 75 basis point rate hike is on the table, and at this time expected, at their next meeting in July. We expect interest rates to continue to move higher, pushing bond prices lower, but are becoming more optimistic on forward prospects for the stock market. Even with the S&P 500 being 23% lower year-to-date it remains higher than two years ago and 25% higher than three years ago. If you have cash available, this might be a good opportunity to be dollar cost averaging.
The volatility and gyrations of the stock market can be stressful, which is why it is important you have a solid plan in place and are sticking with it. It is during times such as this that most investors react emotionally and make errors which have the potential to impact their future savings and possibly their lifestyle. If the market volatility is causing you worry, please reach out to us so we can ensure you are comfortable with your risk level and position your portfolio accordingly.
Have a great week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
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