Last summer, there was a wave of illogical optimism among investors that the Federal Reserve’s interest rate hikes would be short-lived. Then the Fed reiterated its determination to raise rates until inflation is back to its 2% objective, and stock and bond prices wilted.
A greater disconnect between markets and the Fed emerged after markets bottomed in mid-October, even after two further rate hikes. Markets flinched, but quickly resumed their ascent.
What could explain these disconnects? We could be nearing the end of the line in terms of rate hikes. Even if the Fed Funds rate ultimately goes to 5.25%-5.50%, this level would be reached by early May.
Private economists and the Fed are similarly disconnected, with more than half of private economists expecting the Fed to actually cut interest rates in 2023 while no Fed governor has endorsed that view.
While not as premature as market optimism last summer, recent hopefulness strikes us as too much too soon considering that the effects of the Fed’s six rate hikes are only starting to be felt.
When evaluating information that seems out of step with reality, one helpful exercise is to consider what would have to happen for that viewpoint to be correct. In other words, don’t discount the possibility that a seemingly disconnected view might turn out to be correct. Stock prices and bond yield behavior last year were consistent with a recession. 61% of economists in a Wall Street Journal survey expect a recession this year, but a mild one with the weakest period being the second quarter. If they are correct, we are not far away from that point and the recent market optimism starts to make sense.
Investors may have accepted and priced in the odds of a recession and are now looking 6-9 months ahead to the early stages of an economic recovery. In this view, they would be looking past the remaining interest rate hikes because they have accepted the outcome, recession. They aren’t ignoring the Fed, they are just looking farther ahead. But it is all predicated on a moderating inflation rate that allows the Fed to pause its rate hikes rather than persistent inflation that forces the Fed to raise rates higher than anticipated by investors, economists, and even the Fed itself.
Investors should remain buckled in because the ride will be bumpy as the mix of economic news turns negative. It is also important to look for opportunities to prepare for the eventual upturn in the economy.
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