Change In Tone
Equity markets continue to flail around in an effort to find some traction heading into year-end. The weakest part of the seasonality calendar is behind us, and we’ll see if historically strong seasonals starting in mid-October through mid-January hold true to form. It was a mixed week with the S&P 500 and Dow registering gains of +0.47% and +0.79%, respectively while the Nasdaq Composite slipped -0.19% and the Russell 2000 remained in its slumber (down -1.47% for the week). The bond market got a bump with yields slipping in part on a bid for safety with the evolving situation in Israel. I don’t have anything informative to share on that front other than our thoughts and prayers go out to those impacted by the situation.
The most important development over the last week has been the notable shift in Fedspeak with a growing number of members shifting away from the notion that more rate hikes are required to now hinting that the hiking cycle is nearing its end. The shift in messaging is coalescing around the idea that the tightening in financial conditions over the last several weeks – aided and abetted by the rise in interest rates at the long-end of the Treasury curve and an expansion in credit spreads – has done a lot of the heavy lifting for the Fed on the tightening front. We’ve received a couple notable comments from FOMC voting members over the past week starting with St. Louis Fed President Charles Waller:
“Financial Markets are tightening up and they’re going to do some of the work for us.”
He went on to say:
“we’re finally getting very good inflation data…if this continues, we’re pretty much back to our target.”
Not just “good” but “very good”. I think it’s fair to say that the bar for any more rate hikes is now pretty high. Atlanta Fed President, Raphael Bostic was even more emphatic in his speech on October the 10th.
“I think that our policy rate is at a sufficiently restrictive position to get inflation down to 2%. I actually don’t think we need to increase rates anymore.”
Then on Friday at the Delaware State Chamber of Commerce we heard from Patrick Harker, President of the Federal Reserve Bank of Philadelphia.
“I believe that we are at the point where we can hold rates where they are. By doing nothing, we are still doing something. And, actually, we are doing quite a lot. I am sure policy rates are restrictive…”
This is a refreshing development for markets and borrowers but do understand that the ‘higher for longer’ philosophy will be maintained until something breaks. Market-based odds of a Fed rate hike in November are at 8% and 30% for December – pretty well right where the probabilities were before the CPI data hit last week (and lower than the near 50% odds just a few weeks ago). Markets will be listening closely to Jerome Powell’s address to the Economic Club of New York on Thursday.
While the probability has risen that interest rates along the Treasury curve will not increase much from current levels, it does not imply that rates are set to come crashing down anytime soon. Especially with the Atlanta Fed GDP Nowcast forecasting Q3 real GDP to come in around +5.1%. Doubt all you want the ability of the U.S. economy to maintain this level of growth (I know I do), but it’s the reality for the moment and it’s a big number. This degree of strength in the underlying economy should bode well for Q3 earnings that will be rolling out over the next several weeks. In the near-term, markets are likely to take their cue from this good news, in particular given the ongoing sell-off from the July highs, lowered expectations, and depressed breadth readings.
It’s refreshing to see the shift in view at the Fed from what has been a relentlessly hawkish push to one that recognizes the dramatic shift in borrowing rates over the past eighteen months. It wasn’t until I went through the historical numbers over the past twenty years and comparing them to current levels that I truly appreciated how drastic the change has been. See below, but keep in mind that this increase in the cost of capital has yet to fully work its way through the financial system:
Current
Fed Funds Rate: 5.33%
10-Year Treasury Yield: 4.81%
30-Year Fixed Rate Mortgage: 8.05%
Investment Grade Yield: 6.30%
High Yield: 9.19%
Average interest rate level over the past 10 years:
Fed Funds Rate: 1.15%
10-Year Treasury Yield: 2.27%
30-Year Fixed Rate Mortgage: 4.31%
Investment Grade Yield: 3.40%
High Yield: 6.40%
Average interest rate level over the past 20 years:
Fed Funds Rate: 1.45%
10-Year Treasury Yield: 2.89%
30-Year Fixed Rate Mortgage: 4.75%
Investment Grade Yield: 4.15%
High Yield: 7.61%
This is where my confidence in the ‘soft landing’ outlook diverges from the now broadly embraced consensus view. I hold the view that you can, and we will have both a ‘soft landing’ and a ‘hard landing’. This is where appreciating and respecting the nuances of the business cycle are important. When studying past business cycles, you’ll find that ‘hard landings’ follow ‘soft landings’ as ‘soft landings’ are nothing more than a bridge from the expansion stage to the contraction stage of the business cycle.
This also applies to the ‘higher for longer’ narrative being embraced by the consensus. It’s common for the Fed to convince the market that rates will remain higher for longer at the end of a tightening cycle. Rarely in the archives of history will you find Fed language predicting an economic recession, but as night follows day, recessions follow tightening cycles. When central banks near the end of their tightening cycle they always try to convince everyone that rates will stay elevated because guiding markets to anticipate cuts would undermine the tightening they just implemented. However, when you look back over the past three decades the average lag from the last hike to the first cut is 10 months. Find me a time in history where interest rates stayed higher indefinitely. Such a time does not exist. Just as a ‘soft landing’ is real, so too is the ‘high for longer’ rate narrative (for a time), but don’t think for a second that either are permanent. Each represents a point in time on the path of an unfolding economic cycle.
That being said, what we have witnessed these past 18 months is an epic interest rate shock that has yet to be felt. Step back and think about why the Fed implemented the hikes that it did: to slow growth, weaken the labor market, curb inflation, and raise the cost of credit. With the amount of hikes they’ve done already, and QT continue to operate in the background (the Fed’s balance sheet dipped below $8 trillion last week) the Fed will achieve its objectives. What has been challenging about forecasting the ebbs and flows of this business cycle is the magnitude of fiscal stimulus that has been injected in the system which has proven to provide a substantial level of support to extend the cycle. On top of that we had so many households and businesses manage to buy time by locking in cheap financing for their debt. But with the passage of time the increased cost of capital will start to work its way through the system as debts mature and have to be rolled over.
This is a movie coming to a theater near you in the corporate bond market as detailed in the following chart from Goldman Sachs on the upcoming maturity wall that ratchets higher in 2024 and 2025. These companies have run out of runway to stave off the refinancing cycle any longer. The interest rate on Investment Grade credit, at 6.30% today, is nearly 300 basis points above the average of the past decade; and nearly a 400-basis point gap when it comes to mortgage rates.
BofA Merrill Lynch Chief Investment Strategist, Michael Hartnett, published an insightful analysis in his weekly “Flow Show” report where it highlighted that investors are parking capital in cash at an astonishing rate and doing so at a time that yields across the fixed income market have risen to a level that is creating an opportunity for equity-like returns from bonds. The bullet points below are a summary of the data in the accompanying table:
Yield on “benchmark” blended 20% equal-weight bond portfolio of T-bills, 30-year Treasury, IG, HY & EM bonds = 6.8%.
Yield on "higher risk" blended 25% equal-weight bond portfolio of 30-year Treasury, IG BBBs, HY CCCs & EM HY bonds = 9.3%.
Expected 12-month return should yields drop 100bps next year…13% for benchmark portfolio, 17% for higher-risk portfolio.
Expected 12-month return should bond yields rise 100bps next year…-0.2% for benchmark, 1.3% for high-risk.
Suffice it to say the risk/reward profile in the fixed income market has become very favorable where even an additional 100 bps rise in interest rates will have a minimal downside impact on the total return of a diversified portfolio of fixed income instruments. The prevailing view among investors is to shun fixed income investments given their performance over the past two years as yields have moved higher and stocks have outperformed on a relative basis. But such a view focuses too much on what’s in the rearview mirror and not enough on what’s on the horizon.
As for the equity market, outside of an exogenous event catching investors by surprise I think the set-up looks constructive heading into year-end. Q3 earnings season is off to a good start with three of the big banks (JP Morgan, Citi, and Wells Fargo) beating estimates on both the top and bottom line. With the level of nominal GDP growth in Q3 tracking 6-7%, earnings by and large should be strong enough to set a lot of near terms worries at ease. A focus for me at this point in the cycle remains the labor market and thus far it continues to remain solid (jobless claims came in at 209k last week – wake me up when we see this figure closer to 300k). If/when the labor market turns then I think we will be entering the acceleration stage of the transition from ‘soft landing’ to ‘hard landing’, but until then I think investors can hold a broadly diversified portfolio of stocks, bonds, and commodities and not be too worried.
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