Key Points:
- The Fed’s aggressive stance to combat inflation is causing pain in the stock and bond markets as higher rates pushed risk asset prices down.
- Stocks and bonds experienced their worst month of the year with the probability of a recession increasing as the Fed continues to pull liquidity from the system.
- Current yields and valuation levels in stocks and bonds look much more attractive than we have seen in the past few years.
After mischaracterizing inflation as “transitory” last year, the Federal Reserve has been playing catchup in an effort to reign in rising prices this year. The extremely aggressive rate hikes by the Fed to slow down economic activity and ultimately prices has caused pain in the financial markets. Tighter financial conditions increase the probability and depth of a recession. The Fed raised the Fed Funds rate an additional 75bps (0.75%) in September, after raising it 75bps in both June and July meetings. Chairman Powell vowed to “keep at it until the job is done”, suggesting more rate hikes this year. Higher rates from the Fed make their way into the rest of the economy in the form of higher mortgage rates, auto loans and overall borrowing. Eventually the prices of goods will come down but the latest CPI reading of 8.3% in August for the year-over year increase in prices is a far cry from the Fed’s 2% target.
Stocks and bonds experienced their worst month of the year with the S&P500 dropping 9.21% while the Bloomberg US Aggregate Bond Index fell 4.32%. All sectors of the stock market were down sharply with only 27 stocks in the S&P500 having a positive return in September. Interest rates moved higher with the 2-Year Treasury yield climbing above 4.3% after yielding less than 0.3% just a year ago. The rise in yields is bad for existing bonds as their prices adjust (fall) so that their yield reflects prevailing rates. However, their prices will converge back to par assuming there is not a default. Slowing economic activity from higher rates may increase the probability of a default as it could make interest and principal payments harder for borrowers.
The silver lining from higher rates is higher yields in bonds and lower valuations in stocks. Investors are finally earning a return on their cash and relatively attractive yields on their bonds. With stocks down over 20% both in the US and abroad for the year, the high valuations that we experienced in the past few years is no longer an impediment to put money to work. It should also keep long-term investors focusing on the long-term. The Fed will eventually stop raising rates as it isn’t hard to predict what 7% mortgage rates will do to house prices and all the industries associated with new home construction. Clearly the Fed was too late to the game to pull the punch bowl away and the markets will remain volatile until we get inflation under control. The Fed does has some ammunition to cut rates in the event that we do see a sustained recession from tighter financial conditions. The bond market is already pricing that in with an inversion in the yield curve: higher yields on short-term bonds than longer maturities. Sticking to long-term plans is difficult in times like these but trying to time the market with any level of consistently is most certainly harder.
Sources: Morningstar Direct, Wall Street Journal, State Street, St. Louis Fed database