- The Fed raised its short-term interest rate target from near zero to 5.5% over the past two years in an effort to stem inflation
- While Chair Powell did not rule out further hikes, he also signaled that the Fed was ready to “proceed carefully” to see if their actions were enough to bring inflation back to the 2% target, likely meaning no more hikes this cycle
- A variety of factors point towards the job being done and no need for further rate hikes; these factors include lowered inflation, rise in longer-term interest rates, and tightening of financial conditions
- If additional rate hikes are needed, it would be due to sustained increases in inflation; a 2024 recession is still a risk but less likely than previously thought
- There is a balance between rising bond yields and fears of a slowdown; this balance will not remain sustained indefinitely, with bonds or stocks eventually adjusting accordingly
Over the last two years, the Federal Reserve has raised its short-term interest rate target from basically zero to 5.5% in an effort to stem inflation.
Over this time, the Fed has been the dominant story in markets, blamed for everything from the 2022 stock sell-off, a surge in home mortgage rates, the worst bond market performance in decades, and even a brief series of bank failures earlier this year.
But the Fed’s November 1 meeting may finally mark an end to the cycle of rate hikes. While Fed Chair Jerome Powell did not rule out the possibility of further rate increases, he did signal that the Fed was ready to be “patient” and see if their actions to date are enough to bring inflation back to the 2% target. We think this means the most likely outcome is that the Fed has hiked for the last time this cycle.
Does “proceed carefully” mean hikes are over?
Interpreting the Fed’s public communications is often challenging. However, it does have certain tells that one learns to pick up once you’ve been doing this long enough.
With this in mind, let’s consider the following phrase from Powell’s press conference: “Given how far we have come with the uncertainties and risks, the committee is proceeding carefully.”
In context, Powell discussed the fact that there have only been “a few months” of better inflation data, and it is too early to say inflation is on a path to their 2% target. However, there is also a risk that more rate hikes could “weigh on economic activity.” This is the Fed laying the groundwork for why they wouldn’t want to keep blindly hiking until inflation was all the way to 2%. There are risks to doing too much as well as doing too little.
Note that Powell has been setting up this two-sided risk narrative for a couple months now. These kinds of repeated messages from the Fed tell us that they are preparing markets for a shift in strategy.
This leads us back to the “proceeding carefully” comment. This is a very purposefully chosen phrase, one Powell also used in the September press conference. It allows the Fed not to rule out future rate hikes but also prepares the market that more hikes are not a given. Here again, the fact that Powell is repeating the same phrase means it is something they really want markets to hear.
Now, this does not mean there is no chance of additional rate hikes at some point, but Powell has raised the bar. Until recently, the Fed’s default position was to keep hiking. Now, the default position is to remain on hold.
Why stop now?
For months, Chair Powell has told us the Fed would “keep at it until the job is done.” Yet inflation is still well above the Fed’s official 2% target. The most recent Core PCE inflation measure said that inflation was 3.7% over the last year. However, inflation has subsided significantly over the last few months. Specifically, if we look at just the last three months, inflation has only been at a 2.5% annualized pace.
Source: Bureau of Economic Analysis
If the Fed is ending rate hikes now, does that mean the job is done?
When asked about this contrast during the press conference, Powell explained “policy works with lags that are long and variable.” In other words, it takes time for the impact of rate hikes to be fully felt in the economy. Traditionally, economists assumed this lag was as long as 12 months, but all would agree this is more of a rule of thumb than a precise estimate.
Think of it like taking your foot off the accelerator of a car. It doesn’t stop right away; we know that. But how quickly does it slow down? All kinds of factors influence this: how fast was it going before? Is the road going uphill or downhill? How heavy is the car?
The Fed can guess at these things, but it doesn’t know for sure. And since inflation is now heading in the right direction, they can logically conclude that maybe the car will drift into the right place without them having to slam on the brakes.
Another critical factor is the recent jump in longer-term interest rates. Since May 4, the Fed has only hiked its interest rate target by 0.25%, but the 10-year Treasury yield has risen from 3.38% to 4.81% over that same period.
Remember that the Fed’s target only impacts the rates at which banks conduct overnight transactions. While that’s an essential part of the economy, longer-term interest rates are perhaps more important. Borrowing by larger businesses, commercial real estate, and home mortgages are all based on where long-term interest rates are, not the Fed’s overnight rate.
If these rates are rising, that will clearly have an influence on economic activity. E.g., if it is more expensive for businesses to borrow, they are less likely to buy equipment, expand operations, and hire more employees. Indeed, the surge in home mortgage rates has had a significant impact on the housing market.
All of this is likely to put some additional downward pressure on inflation, and the Fed is taking this into consideration. Powell said that, “Financial conditions have clearly tightened quite a bit” and specifically cited the fact that mortgage rates are close to 8%. He added that “over time, that will have an effect.”
What would cause the Fed to restart hikes?
As we said above, the Fed might have to hike again at some point, but the bar has been raised. For most of the last 18 months, the Fed used any sign of the economy gaining strength as a reason why they should hike all the more. That will no longer be the case.
Things like somewhat stronger job gains, consumer spending, or even higher stock prices were once reasons to ramp up rate hikes. Now, the Fed won’t be especially worried about any of these.
If the Fed does wind up hiking again, it will be because inflation increases in a sustained fashion. I.e., it won’t be one or two months of somewhat higher inflation figures, but something that persists long enough to convince the Fed that they should risk damaging the economy.
We think the odds that this occurs are low, but not zero. We would also say that if this happens, it would come sometime during the first quarter of 2024 at the earliest.
Longer-term rates have been rising, but there’s a limit
The surge mentioned above in long-term interest rates has been painful for bond investors. Through June 30, the Morningstar U.S. Core Bond index was up just over 2% for the year. However, rising bond yields have taken a toll in the second half of the year, causing the index to fall more than 4%, erasing all gains for 2023. If the year ended today, bonds would have suffered their first three-year loss ever.
However, it’s worth noting that there is a limit to how high long-term rates can rise. Namely, it would be extremely challenging under today’s circumstances for the 5 or 10-year Treasury bond yield to rise above the Fed’s target rate of 5.5%. In other words, the yield curve will almost certainly remain inverted for a while longer.
The reason is that these longer-term rates are primarily a function of the market’s anticipated average Fed target over the bond’s term. I.e., the yield on the 10-year Treasury should roughly be the market’s best guess at the average Fed target over the next ten years. We discussed this phenomenon in more detail in a past article about yield curve inversions.
Given this fact, for the 10-year yield to rise above the current Fed target, it would imply that the long-term average Fed target is higher than today’s level. Put another way, the Fed never cuts over the course of the next ten years. We’ve recently written much about the “soft landing” and how near-term recession risk has declined. But eventually, there is going to be a recession, and whenever that happens, the Fed is undoubtedly going to cut rates by some degree.
So, as long as the economy hasn’t reached some permanent state of strong growth, these longer-term yields are at least close to as high as they can reasonably reach.
Are stocks worried about a slowdown?
The stock market has struggled over the last few weeks, with the S&P 500 falling almost 9% since its July 31 peak. Part of that is related to the lurch higher in bond yields and recent earnings reports. Several companies have been warning that their revenue growth could fall below expectations in 2024, perhaps due to the economy generally slowing.
Facet remains of the view that a 2024 recession is a risk, although we think a recession is less likely now than we would have said a year ago. Within Facet’s equity ETF mix, we still have an overweight of companies with certain defensive characteristics, like high-profit margins, low debt burdens, and relatively steady revenue generation.
Regardless, something has to give between rising bond yields and fears of an economic slowdown. If the economy is going to slow down, then bond yields are way too high. If the economy continues to grow at a strong clip, bond yields will probably remain high, but stocks are very likely to rise.
We don’t know which way it will break in 2024, but the current balance between stock price moves and bond yields won’t be sustained.