The Last Hike?
As usual, the Fed created some fireworks in financial markets this week. This time it was a positive reaction across most asset classes such as stocks and bonds.
The S&P 500 rallied just over 1% on Wednesday while the US 10-year treasury yield dropped to 4.73% after topping 5% a few days ago. In fact, this was the best week for financial markets all year with stocks up just over 5%.
What caused the positive reaction in markets?
Mr. Powell believes that the interest rate hikes by the Fed in the past 18 months are starting to create the intended consequences for the economy. Higher rates lead to slower economic activity, possibly creating a recession or something less severe. As with all previous interest rate hiking cycles, there is a point in time where more hikes become unnecessary to avoid economic damage.
Judging by the reaction of financial markets, “it” is saying the Fed is done, and that is why we are seeing both stocks and bonds rally. Bond prices are going up while the yield, or interest rate, is going down.
An important caveat in my opinion is that we still have a tight labor market, but that might be changing too. Unemployment is still near all-time lows and there are still millions of excess job openings. Recent labor data suggests that maybe this is turning in the market's favor as demonstrated by Friday's soft October jobs report. But, if the employment picture doesn’t improve (as in more layoffs, higher unemployment rate) counterintuitively, this could push up inflation, which in turn would mean the market is wrong and we see more interest rate hikes.
What happens after the last hike?
In my opinion, in an ideal world in terms of market behavior, the best-case scenario is that we are at the current level of interest rates for at least another 6 months, maybe longer. We do have an election coming up about a year from now, which does create some complications (a discussion for another letter). As of now, if we hold steady that means the economy is still holding its own in the face of these elevated rates.
If the Fed is forced to step in and cut rates in the next few months, it would most likely be because something has gone wrong in financial markets. Whether it’s more bank failures leading to a systemic risk event, some other event having to do with debt, or… name your extreme event. It is a low probability but if the Fed is forced to cut prematurely it probably won’t be for a good reason.
That said, after the final rate hike (which as of now was the end of July) on average we only go about 8 months before the first interest rate cut. If that average were true this time around, we’d be seeing rates dropping by around February of 2024. That’ll be here before we know it!
So, if history is any guide and if the market is right, we could see interest rates dropping sooner than many expect. I am skeptical of that, but we will see. We have seen a lot of “firsts” over the past few years, so nothing should come as a surprise as we start to approach 2024.
How has the stock market done following the last hike?
This question is easy to cherry-pick. Take a look at the chart below. I highlighted the last five interest rate hiking end dates. Six months later the stock market was up on average 12.44% and a year later 15.38%.
Final Fed rate hikes
Source: S&P data
Oddly enough, the last rate hike leading up to the financial crisis of 2008 was in June of 2006. The stock market was up more than average a year later and we all know what happened shortly after that.
If you look back to every single last rate hike cycle conclusion, the results are mixed (hard to believe the Fed as an institution has only been around since 1913). Basically, the market is flat looking out 6-12 months. It ultimately depends on the underlying fundamentals of the economy.
Investment Opportunities?
It will depend on what happens with inflation, but investors might look back on 2023 and wish they bought more bonds. Yields are extremely attractive across many bond sectors and for those looking to take income, locking in these yields might make sense for you. Historically, bonds have NOT outperformed stocks over an extended period, so your specific timeframe and risk tolerance are important to consider.
High-yield bonds (basically bonds that are issued by a company with a sub-perfect credit rating) were yielding around 4% just two years ago. Many are now yielding close to double digits! If it’s retirement income you need, investors might not need to take as much risk as was necessary a few years ago to generate a reasonable return.
Conclusion
I am almost sure I say this in every market commentary. The trajectory of interest rates is so important to the economy and markets, and how Mr. Powell navigates these complex dynamics with inflation will have a lot of influence on the investor experience over the next year. I will continue to keep you updated on important events and help you stay grounded along your investment journey.