Economics was my college major and I took almost every elective I could before I graduated. Every day we are bombarded with economic statistics showing the current state of employment, inflation, interest rates, economic growth, etc. etc. Sometimes the capital markets “like” the news and sometimes they don’t! But, as my I learned from the Chief Investment Officer at my old firm, it turns out that “Timing is Everything!”
When the Fed announces a “tightening” to help fight inflation (usually not a good time to be in equities!), as they did in March of 2022, the goal is to help slow down the economy so that aggregate demand is decreased so that there is less upward pressure on prices (inflation). But, and this is a big “but”, it takes some TIME for an interest rate hike to take effect on the economy – the initial impact is to see short rates RISE as the Fed controls the short end of the curve through the Fed Funds rate.
But, the impact on the long end of the curve (10-years and longer) is less easy to predict. Initially, because there is inflation present in the economy, the impact on long rates could be for those rates to rise, too, because the market demands an “inflation premium” to entice purchasers of long-dated bonds. However, a countervailing force that indicates an “expectation” of a slower economy and less demand for credit implies that long-dated interest rates will actually go down. In this case, it is all about timing and the lag effect and how long it takes for the interest rate hike to cause rates to eventually actually decline!
As seen from the chart below from the Federal Reserve Bank of St. Louis, we have seen this dichotomy of interest rate movement play out during this market cycle. When the Fed started raising rates in March of 2022, the impact was to push long rates up a bit initially (the blue line) and then continuing to trend up to follow Fed Fund rate increases (the olive and red lines) through the end of 2022 due to the inflation premium - an expectation of a slowing economy was not priced into the markets.
During mid-2023, rates began to moderate a bit due to some perceived slowdown in inflation, but this did not persist. Continued increases in the Fed Funds rate into August 2023 showed a sharp increase in long rates to over 4% closing in on currently 5% thus implying that the markets continued to be less focused on an economic slowdown and more focused on more persistent inflation.
It is difficult to know what a “normal” yield curve looks like given the extreme low rates we have seen since the Great Recession in 2008 and difficult to gauge exactly how the equity markets and individual stocks will respond. Certainly, except for the “Magnificent 7” that have defied most of the negative impacts during the economic and geopolitical turmoil of 2023, the bulk of U.S. stocks are struggling in the current environment. For example, through today the YTD total return of the cap-weighted S&P 500 index fund (IVV) is +8.7% (due to overweighted inclusion of the Magnificent 7) compared to the equal-weighted S&P 500 index fund (RSP) of -4.1%. Truly an extraordinary relationship!
There is an old saying about “not fighting the Fed” since they can control the short end of the yield curve and, ultimately, the economic environment; and interest rates levels do not necessarily determine equity returns (as we have seen with the Magnificent 7”!) No one can time the markets so it is always best to stay fully invested with a “tilt” to reflect the current environment. Certainly, in this environment we believe that a higher quality equity portfolio (to weather a problematic economic landscape) and a shorter bond duration (to weather potential for “higher for longer” interest rates) is a prudent strategy until we return to a “growth” phase that will turn equities higher with normalized interest rates.