- The Federal Reserve's interest rate policy remains decidedly hawkish.
- Higher rates make it harder for stocks to find their footing.
- Rising yields mean bonds are increasingly attractive relative to stocks.
- Declining sentiment suggests we may be getting due for a rally, but durability is a big question mark.
It may be hard to believe, but there was a time when the Federal Reserve didn’t broadly forecast its thinking ahead of time. The Bank kept its cards tight to its vest, leaving the marketplace to hem and haw over policy direction. Now? Not so much. We’re acutely aware of their plans. Perhaps, too much so.
On Wednesday, the Federal Reserve announced its latest decision on interest rates. The 0.75% increase in the Fed Funds rate – the rate banks charge each other for loans – surprised nobody. In a terse speech at Jackson Hole last month, Fed Chairperson Jerome Powell told everyone to expect higher rates that last as long as necessary to lower inflation, even if it means pain (i.e. lower net worth and job losses) to households and businesses.
What happens with interest rates next?
The market heard Powell’s message loud and clear, especially following a hotter-than-hoped consumer price index report earlier this month showing inflation remains stubbornly high.
The CME’s FedWatch tool will likely change significantly in the coming days as everybody dissects the post-hike Fed comments, but, for now, odds are rates will be much higher exiting 2022 than previously thought.
In today’s Morning Recon, Real Money’s Stephen Guilfoyle writes:
“Futures markets trading in Chicago are now pricing in an 84% probability for a 75 basis point increase (to the Fed Funds Rate target) this afternoon. This would take the FFR up to 3% to 3.25%, from 2.25% to 2.5% where it is now. Futures are also pricing in a 74% likelihood for another 75 basis points on November 2nd and a 53% probability for an additional 50 bps on December 14th to leave the target rate at 4.25% to 4.5% by year's end. These same markets show a projected terminal target rate of 4.5% to 4.75% to be reached by March 2023.”
If those odds hold, a cumulative 1.5% increase in rates from here will pose additional risks to already sagging economic activity. GDP fell 1.6% and 0.6% in Q1 and Q2, respectively, and GDP isn’t looking healthy in the third quarter.
Guilfoyle notes that “the Atlanta Fed once again revised their GDPNow real-time model for Q3 economic growth down from +0.5% to +0.3% (q/q SAAR) on Tuesday after that report on housing starts forced Atlanta to downgrade the Q3 contribution from residential investment. This comes after Atlanta had to take the quarter from +1.3% to +0.5% last week.”
The trend this year has been for Atlanta’s GDPNow estimate to fall through the quarter into the release of the official data the following month. As Real Money Pro’s Bret Jensen points out, “the Atlanta Fed GDPNow's projection for 2.6% growth in the third quarter that it issued at the start of September.” The data expected in the coming weeks isn’t likely to be great, leaving Jensen to write that he “would not be surprised if that GDP projection is negative by the time the month ends.”
What do rate hikes mean for stocks?
Stocks remain in a bear market, and bear markets are notorious for tantalizing bounces that fizzle out when indexes reach resistance. A big reason why those rallies fail is that as rates rise, Treasury yields climb, increasing the risk-free rate used in discounted cash flow models. A tougher comparison to guaranteed returns forces a lower revaluation, particularly in companies heavily reliant on future growth for profitability.
Increasing rates also make bond yields tastier relative to stocks, particularly in periods of high volatility like we’re experiencing now. Real Money Pro’s Doug Kass reminds us that rising Treasury yields have made them more compelling, particularly to retirees dependent on steady account balances and income streams.
The negative impact of higher rates on earnings is also a drag. Analysts are notoriously late to increase and decrease estimates. We’ve seen some ratcheting back lately, but forward earnings outlooks remain arguably too bullish given macro headwinds.
Action Alerts PLUS co-Portfolio managers Bob Lang and Chris Versace wrote earlier this month:
“Earnings per share expectations for the current quarter and how they have, since June 30, fallen 5.5%... consensus EPS expectations have already been coming down for 2023, even though many companies have yet to share firm forecasts for the coming year. Typically they tend to issue that formal guidance in January, but given the number of headwinds, we'd be more surprised if 2023 expectations were unchanged. But even after the revisions of late, which can be seen below, the expectation is EPS will still grow almost 8% in 2023 vs. 2022…With companies calling out recession worries as well as announcing layoffs and spending cuts, the risk of a recession is more than a passing notion, especially since has yet to be reflected in 2023 consensus EPS expectations.”
The Smart Play
The Fed’s still our enemy; historically, that’s not good news for stock prices. I’ve shared this table many times this year, but here it is again for new members. It’s from Marty Zweig's Winning on Wall Street (1997 edition), and it shows that returns are tougher to come by when the Fed is raising rates. Currently, his Fed indicator is at “extremely bearish” levels.
That said, stocks rally before the market, and the market rallies before the economy. Some individual stocks have put in higher lows since May’s low on the S&P 500, and recessionary baskets like utilities have provided a bit of a safe harbor.
Market sentiment has worsened since I wrote “Is It A Good Time To Sell Some Stocks” on August 17th. It wouldn’t take much more selling for the market to be oversold, so don’t be surprised if we get a rally. The critical question is whether it lasts.
If you’re a short-term trader, stay nimble, avoid leverage, and focus on lower volatility stocks using stop losses, so you don’t risk being caught flat-footed. The defensive playbook also includes maintaining cash as a position, shorting stocks or the index on rallies, or buying inverse market ETFs at resistance. Longer-term investors should continue averaging into the market because historically, increasing how much you buy of the S&P 500 every month during a bear market has paid off.
Investors may also want to consider taking a swing at bonds. Series I Savings Bonds yield 9.62% for the first six months if you buy before October 31. The 2-year Treasury yield is 4%, and the 3-month T-bill yields 3.3%. The 20-year Treasury ETF TLT has fallen sharply this year (longer-term bonds become less valuable when short-term rates increase) and may arguably be tradeable for an oversold bounce if you are risk tolerant.