One Page: One Piece of the puzzle #3.
Federal Fund Rates
“The term federal funds rate refers to the target interest rate set by the Federal Open Market Committee (FOMC). This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight.” Investopedia
The Fed rarely does nothing. Therefore, the information you hear from it is either forecasting upcoming hikes or rate cuts. When the Fed mentions not raising rates (or doing nothing), it likely means they are thinking about a pivot. The Fed will forecast higher rate hikes as they have been doing until they have finished their work on fighting inflation.
The Purpose of the Fed Rates
Essentially, the Fed is either slowing the economy or stimulating economy. You can see this in the chart below. The black dotted line is the Fed target rate. You can see it is typically trending in one direction, either up (slowing the economy) or down (stimulating the economy). Sure, it can stay flat when it is essentially zero, but it is accommodating growth. Just think of rate hikes as stepping on the brakes in your car. You will slow your car down, and in this case, the Fed is slowing the economy. Conversely, lowering rates is like taking your foot off the brakes and stepping on the gas pedal.
Source of data: Bloomberg. Chart created by Jonathan V. Bever
Currently, the Fed has been raising rates and forecasting more rate hikes. The result: a slowing economy, a strengthening of the dollar, a lower price-to-earnings multiple on the S&P, and more attractive yields for bond investors.
When the Fed suggests it is going to slow its rate hikes or pause, what that means is they are considering a pivot. The market responds immediately to this news, taken as a metaphorical pivot, and rate cuts will begin to be priced in, and the dollar will weaken. Therefore, the Fed must maintain its hawkish rhetoric until the desired result is achieved. Let's look at the U.S. dollar chart. The dollar has been going up all year as the Fed has raised rates. Yet, while the Fed has not announced anything other than rate hikes, the dollar has been coming down. It is a little early to call this downward move a trend, but it is one indicator to consider regarding the end of the rate hikes.
Source of data: Bloomberg. Chart created by Jonathan V. Bever
Our thesis is that the Fed will have to pivot sooner than later because parts of the economy cannot handle many rate hikes for very long. Our argument is that the Fed has little room to raise rates without inducing a financial crisis. The Fed chose a strong dollar and higher rate hikes because inflation was too hot. We believe the Fed cycle, which used to take years, has shortened because today, the amplification of all the economic waves have shortened. Recessions have shortened. As soon as the Fed can point to data showing inflation has slowed enough, the Fed will reverse course.
Treasury Yield Curve
What Is a Yield Curve? “A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.” Investopedia
You can see the short-term yields are higher than the longer-term yields. This graph illustrates the various treasury yields along a timeline. This is called the yield curve.
Source of data: Bloomberg. Chart created by Jonathan V. Bever
This curve is inverted when short-term yields are higher than longer-term yields. One would expect to get paid more for the risk of lending for a longer period. When the yield curve becomes inverted (short-term rates are higher than longer-term rates), it indicates a recession is looming. Further, it is an indicator that inflation will be coming down.
The expectation theory of interest rates suggests that when rates are expected to go up, they will, and conversely when they are expected to go down, they will. The short-term rates have gone up because the Fed raised rates. So why isn't the long end going up? According to this theory, it is because: either the aggressive rate hikes will bring a recession or that inflation will come down on its own. In a recession, the demand for borrowing money goes down - less demand, less yield. The Fed probably hopes the longer-term rates will go higher, but they won't if the Fed signals that they are about to pivot too soon.
Let's look at inflation as measured by CPI and PCE.
The Fed looks at both and has been hawkish because the inflation in both cases has not been as transitory as once suggested. It seems to us that the growth rate of inflation has peaked and will be coming down.
Conclusion
It appears the Fed's rate hikes are doing their job. There are signs suggesting hikes may be closer to the end. However, the stock market volatility will continue as earnings are adjusted lower for the S&P, the economy continues to slow, and until there is clarity on the final Fed target rate (called the terminal rate). Nevertheless, we believe the worst is likely behind us, and the bear market may be nearing its end. Until we know for sure, proceed with caution. However, when the headlines quote the Fed being a big hawk on inflation and the market is going down, it is probably a buying opportunity. Finally, bull markets climb the wall of worry. If the market goes up while earnings are being adjusted lower, and the Fed has not changed its policy, then we may indeed have the beginning of a bull market.