The Chopping Block
by Zach Marsh on May 6, 2022
We witnessed another choppy week in the stock market. On Wednesday the Fed announced that it was raising the Federal Funds rate by 0.50%, but further announced that it was not considering future hikes of 0.75% or 1.0%. It did, however, say that it foresees the need to raise another 50 basis points at each of its next two meetings. The market’s immediate response to this news was to send the S&P 500 up by over 3% Wednesday afternoon. The following day, the market took it all back and then some, dropping over 3.5%. At current writing, the market sits moderately lower on the week, but given the dramatic nature of the week’s moves that can change drastically by the end of the day.
Confounding market analyst’s this week is the continued rise in longer term interest rates. The yield on the US 10-year note rose from 2.938% to 3.107% this week. That same interest rate has now more than doubled since the start of the year. The first 4 months of the trading year has been one of the worst four months on record for 60/40 stock bond portfolio, down 12.54%. Since 1993 only 3 other 4-month periods have been worse. This one stands out as it is the only time stocks and bonds have declined in tandem. While US Total Stock Market Index has declined 14.01%, the return on the 10-year bond has declined 10.33%. In fact, since 1993, there has never been a four-month period when stocks have declined by more than 10% and bonds have not been higher. To say this year has been painful for investors is putting it mildly, as there has been nowhere to hide. It seems that the market may be taking this inflation more seriously than the Fed.
Typical periods of Fed hiking coincide with a flattening of the yield curve, short-term rates rising faster than intermediate to long-term rates. We began to see that earlier in the year when the curve briefly inverted (short rates higher than longer-term rates) in early April. Since then, the curve has steepened dramatically. The rise in longer-term rates can create greater stress on financial assets. Since the Financial Crisis of 2008 sent 10-year rates below 3% there have been 3 other periods where the 10-year touched 3%, 2011, 2013, and 2018. In 2011, the S&P 500 fell nearly 15% in the following 6 months. In 2013 the S&P 500 managed to gain 7.6% in six months. In 2018 the S&P 500 dropped over 11% before the Fed blinked and reversed course on its rate hiking regime.
Compounding problems is that a big driver of this recent economic expansion has been the housing market. 30-year mortgage rates hit a low of 2.67% at the end of 2020, that rate is now over 5.25%. Cheap mortgage rates not only fuel the housing market, but also the consumer spending market as consumers can borrow against their home to fund renovations or any other spending needs. The sharp rise in mortgage rates may crush consumer demand.
Tamping down consumer demand is not necessarily a bad thing as we look to bring down runaway inflation. But it is a delicate balance between tamping down and smothering. During his press conference after the rate announcement, Fed Chair Jerome Powell said that he was optimistic that the economy can avoid a “hard landing,” economic speak for recession. However, a day later when the Bank of England announced a rate hike of their own, a more candid or honest assessment came from its Chair who said that a recession later this year is nearly certain.
I know a thing or two about European realism versus American optimism, but I have to side with the Bank of England on this one. The current pace of consumer interest rates coupled with the relentless rise in commodity prices seems to create an unavoidable recession in our near future. Which probably explains why the market is acting the way it is right now. Fortunately, given that markets are typically ahead of the curve, and assuming this isn’t another financial crisis, the market declines may be closer to the end than the beginning. Even if the economic downturn isn’t.
Thanks for reading,
Zach and Dave
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