The Federal Open Market Committee (FOMC) continues to hold steadfast on their policy of elevated rates and maintaining them higher for longer. Currently, the policy rate target stands at a range of 5.25% to 5.50%. At the last FOMC meeting, held on September 20, 2023, they chose not to raise rates for only the second time during the current hiking cycle (began March 2022).
While two pauses in the last three meetings are a welcome development, when compared with the number of rate hikes that have been made since March 2022, the FOMC continues to suggest that one more hike might be needed, and rates will be “higher for longer”. The Market, however, has a different view of what the FOMC might do in the future. The Market’s current forecast suggests a probability of future rate hikes at an 82% chance of another pause at the November meeting, while there is a 65% chance of the pause continuing at the December meeting (31% chance of 5.50%-5.75% and 4% of 5.75%-6.00%). It is important to note that these probabilities are in a constant state of flux as the market moves and as additional data is released, notably economic data, these probabilities react to those releases. The blue diamond (on the next graph) is indicative of this additional hike the FOMC is forecasting (5.60% by year end – implying rates 5.50% - 5.75%), while the green diamond is indicative of an FOMC pause and no further hikes. The blue diamond references the FOMC’s own forecast while the green is what the Market is suggesting. What has changed dramatically since my last quarterly message is the forecast for next year. As of June 30th, 2023, the FOMC and Market were both indicating rate cuts of 1% in 2024, the FOMC now only suggests 0.50% of cuts next year, while the Market suggests there will be cuts of 0.75%. Note that the long-term target maintains the view that rates heading back to 2.50%, or rates cut in half from where we currently stand.
Inflation has continued to move lower, but the pace of decline has slowed, and in some areas it has increased slightly. One area that has seen an increase is oil/energy prices. FOMC rate decisions have no impact on how OPEC decides to supply the world with oil. Those nations are independent from the FOMC and decide whether to add or remove supply from the market. This year, some OPEC nations have chosen to cut production, causing prices to increase. Short-term increases in oil can mostly be absorbed, but the longer those prices stay elevated, the more entrenched inflation can become in other sectors. JPMorgan produces an excellent graphic, or heat map, that I used in my last quarterly letter, as well as below. This heat map shows all the granular pieces of the Consumer Price Index (CPI) and while most of us only read about the headline number, the individual pieces matter. By focusing on the colors below, you can see that all areas of inflation, save for energy, continue to show decline/cooling (red = inflation is overheating vs green = inflation is cooling). The data coming out is clear, inflation is continuing to cool. This is welcome news as it should alleviate the pressure on the FOMC to continue with rate hikes.
The FOMC prefers a different measure of inflation, the Personal Consumption Expenditures (PCE). They would like to see PCE in the 2% range. The August report was released on Friday, September 29th and continues to echo what we are seeing in CPI. In fact, it came in at the lowest since Q4 2020 and the year-over-year figure dipped below 4% (3.9% actual) for the first time since the FOMC began the current hiking cycle. While it has not come down to the 2% range the FOMC is seeking, it is on the right path and continues to make progress in the right direction. This is further evidence of the need for patience and not to have knee-jerk reactions (i.e., additional rate hikes)
Another salient point to mention is that the Fed Funds Rate has finally surpassed the rate of inflation. This also points to just how restrictive rates the current rates are, as illustrated below. This is the first time, since the FOMC began raising rates, that the policy rate has exceeded inflation. This is just another fact to show the present rates are restrictive and no additional hikes are necessary.
In “4th Quarter 2022: Don’t Fight the Fed…” piece, I noted a CNBC article that suggests it takes between 12-18 months for the full effect of a rate hike to be felt in the economy. Putting data behind that analysis, 18 months ago the Fed Funds Rate was at 1.63% and 12 months ago it was at 3.13%. Those figures illustrate the extreme pace the FOMC has moved, when compared to the 5.25% - 5.50% rates we see today. This difference also illustrates how much has yet to be felt.
Those that have sought to take on a new mortgage, finance a car, or have revolving balances on credit cards have felt this pain first-hand. Mortgages have moved from 3.6% to 7.6% while credit cards have jumped from 16.2% to 24.4%! Note, these figures are national averages. These abrupt changes in interest rates are costing consumers more. They are yet another factor exhausting savings or resulting in a smaller chunk of disposable income available for discretionary spending and resulting in less money available for consumers savings. Consumers were already feeling the impact of inflation on household staples and groceries, higher interest rates further erode disposable income.
For the first time ever, year-over-year money growth as measured by M2 (money supply) is negative. When we combine all these ingredients it is evident that what the FOMC is doing is working to slow inflation and there are still the lagged effects of the rate hikes that have yet to be felt. The consumer has less money to spend and that too should help alleviate demand and excess.
The job market continues to show strength as does the economy (GDP). Even more reason for the FOMC not to press things too far and risk unintended consequences. The present strength in jobs, economy and earnings forecasts illustrate there is still a potential for a soft landing. Or the ability of the FOMC to raise rates just enough to cool inflation, while not pushing the US economy into a recession.
The 10-Year US Treasury Note yield increased 0.78% during the quarter while the 2-Year Note increased by 0.17%. This is welcome news for a couple of reasons. This suggests that the yield curve is beginning to normalize. Yield curve inversion (versus a normalized curve) is when short-term rates are higher than long-term. If one were to invest in an interest-bearing security, the longer one is willing to lock up their funds, the higher the interest rate should be. Currently, that is not the case. One can earn 5.04% on a 2-year US Treasury Note versus 4.59% on a 10-year. As it becomes evident that the FOMC is pausing, or even lowering rates, the more this inversion should normalize. Curve normalization can happen one of two ways; the FOMC can lower their policy rates which will bring down short-term interest rates and at some point, they will fall below long-term rates, or by the FOMC holding rates higher while maintaining a pause, this could push up long-term rates and they could potentially exceed short-term. Obviously, some combination of those two is another possibility. Since the end of the second quarter, long-term rates rose 4.5 times the rate as short-term (0.78% vs 0.17%). Furthermore, the FOMC’s projections of fewer cuts next year also elevate the 10-year yield.
Yield curve inversion typically refers to the interest rate on the 2-Year US Treasury Note exceeding that of the 10-Year US Treasury Note, but it can also be measured by looking at the 3-Month Treasury versus the 10-year. Historically, this inversion has been a precursor to a recession.
Source: Yahoo Finance and St. Louis FRED
The increase in the 10-year yield over the last quarter was an additional factor that seemed to weigh on the stock market. The S&P 500 is still up double-digits at 11.7% through the first nine months of the year, but we were up 15.9% through June. This quarter saw the S&P 500 slide 3.6%. One should not forget that a 11.7% return exceeds the long-term averages of the stock market. Until the FOMC changes directions and begins to lower rates, we remain in a hiking cycle. The uncertainty around when the FOMC will end their hikes and finally lower rates continues to bring volatility to the stock market. The chart below highlights the divergence of rates and the stock market.
Source: Yahoo Finance and St. Louis FRED
Anecdotal data of trends in Google searches is another layer of the onion we can peel back to understand what folks are searching for. Searches for “soft landing” have well outpaced those for “recession” over the last 12-months and the shift is visible towards more folks searching for the term, “soft landing” as of late.
Soft Landing Searches
There is a silver lining here, the chart below illustrates how previous years performed when the market was up at least 10% in the first half of the year. Note the consolidation in August, September, and October is highlighted below. The years that are similar to 2023 are referenced at the bottom of the chart. On average, these years were up 24.94% for the full year.
In conclusion, interest rates have risen more than five-fold in the last 18 months and some of the lagging effects have yet to be felt. Inflation is slowing, the FOMC has paused twice in the last three meetings, interest rates exceed inflation, consumers appear to have spent down much of the excess funds that were distributed during the pandemic, and the Market points to the FOMC having raised rates for the last time. Additionally, the market and the FOMC are pointing to lower rates in 2024 and beyond. The FOMC remains “data dependent”, as we continue to hear them reiterate, and the data points to inflation cooling. The hope is that the soft-landing scenario becomes reality, as we wait for the end of the FOMC rate hike cycle.
If you have any questions or would like to discuss your personal circumstances, please do not hesitate to reach out to me.
Rob Leiphart, CFP®