Investors made a huge mistake this summer when they misread the economy and worse, misread the intentions of theFederal Reserve. The magnitude of the error was revealed on Tuesday and led to the biggest selloff in at least two years.
But the error – belief that the peak of theinflation will allow the Fed to start lowering interest rates after raising them to some peak early next year – continuing to underpin the price of bonds, stocks and futures.
This is an easy mistake to make, because – in the absence of hyperinflation and corporate collapse – inflation will eventually return to low levels. But investors were far too optimistic that this would happen soon, in the face of clear evidence that inflation is stuck well above the 2% the Fed wants and clear warnings from the Fed itself that the market is reading the picture wrong.
The danger is that stocks and bonds are expected to fall further because investors are still clinging to the remnants of faith that inflation will soon be defeated, a bad recession will be avoided and then the Fed will be free to stop raising interest rates and then start easing policy.
Tuesday’s inflation data squashed the idea that the Fed would stop soon. Excluding the volatile food and energy prices, prices rose by 0.6%, more than 7% on an annual basis and more than at any time since 1991 until the pandemic.
Other methods the Fed uses to filter the signal from the noise have shown equally dire results: the median increase, an average that cuts out the biggest and smallest price changes that tend to confuse, and the increase in “sticky” prices that don’t change often.
The markets reacted as they should. Bets on interest rate hikes have moved to a one-third chance of a full percent hike at next week’s meeting, something the Fed hasn’t done since 1984. Peak interest rates now aren’t expected to be reached until March 2023, and will be higher than previously thought, above 4%.
But hope lives on, and we see it both in stocks and in bets on the Fed.
The stocks most sensitive to bond yields are those with most of the profits going far into the future, so-called growth stocks. These took a hit from the rise in bond yields this year until mid-June, then rebounded when most bond yields were in retreat, and got hit again when yields rose again Since mid-August.
In the meantime, everything is as usual, at least in terms of what has happened in recent years. But the Treasury’s 10-year bond is now just shy of its mid-June peak of 3.48%, while growth stocks have lost only about half of what they gained in a two-month summer rally that ended in mid-August.
Something is happening here, and that something is hope. In June, investors seemed to be giving up, but growing hope that inflation would subside and the Fed could ease pushed the S&P 500 up 17% over the summer. About half of that gain has since been reversed, but investors are still clinging to the belief that things will get better soon.
To be fair, things are getting better. The easing of corona restrictions and a shift in demand from products to services have eased the load in ports, truck fleets and chip suppliers.
The price of oil hovers around $90 per barrel, compared to more than $120 in June. Important commodities such as copper are down more than 20% from this year’s highs. And sea freight costs have dropped, and this is quickly transferring to store prices. The crisis in Europe and the housing crisis in China and endless corona closures should also help moderate global demand, and reduce the pressure on consumer goods.
All of this helps explain how investors are able to cling to their belief that the Fed will stop raising interest rates early next year and start easing policy again by the end of the year.
And he has a stupid faith! Monetary policy has long and variable delays before it reaches the economy, so even the first interest rate hike came in March, not sure if its impact was felt yet, let alone the bigger hikes that followed. Next year those high interest rates will hurt demand, leaving less of the pandemic-era savings that helped support spending. The combination of weakened demand and improved supply will be perfect for lowering inflation.
Still, overall demand remains high, wages are rising rapidly and there are fewer signs of the kind of economic trouble that will cause prices to crash. Worse, Fed policymakers continue to reject the idea that lower interest rates could come quickly after the rate hikes stop.
One thing that would almost certainly cause the Fed to lower interest rates would be a recession, because a shrinking economy often crushes demand and stops inflation. But the markets are not seriously preparing for a recession, and the bets assume instead that inflation will fall sharply without killing the economy.
Corporate bond prices hint at a higher chance that the weakest companies in the market will go to the wall. But junk bonds give a higher yield than Treasury bonds by only 4.68%, according to the ICE BofA US High Yield index, much less than even the recession scare In 2018, not to mention cases of real recession.
Stock prices began to show concern about a recession a few months ago, and mutual fund managers who responded to a Bank of America survey said the overall likelihood was toward a recession. But a recession remains a secondary consideration in valuations—a proxy for sensitivity to interest rate changes—as a driver of prices, and highly valued stocks fell the most. A lot when bond yields rose.
All in all, it remains a one-bet market. If you believe inflation will go down on its own and the Fed will respond by cutting interest rates next year, stocks and corporate bonds look reasonable. If you think the Fed will do what it says, they are still too expensive.