The hawks are back.
In testimony before the Senate Banking Committee last week, Federal Reserve Chairman Jerome Powell once again turned hawkish, saying that the Fed will likely raise interest rates higher than markets have been expecting.
Not long ago, futures markets were predicting the Fed would stop raising its target interest rate when it reached 5%. After Powell’s testimony last week, that changed to a terminal rate of 5.5% – a whopping half-percentage point higher than previously expected. (Though it’s been dialed back a bit since the two recent bank failures.)
Here’s how the futures market now prices the probability of various rate levels once the May 3 meeting of the Fed’s interest rate setting committee wraps up. You can see that it assigns the largest probability – about 58% – to a rate of 5.25% after that meeting.
And here’s how the stock market reacted to Powell’s testimony the morning of the announcement.
Powell’s testimony put an abrupt end to the brief March market rally that had pushed the S&P 500 Index up 2.5% since the beginning of the month. And bond yields jumped on the news, with the 10-year Treasury close to 4%. (Bond prices fall in periods of rising rates, so their yields rise.)
Thanks a lot, Jay!
Fear of the Fed
Clearly, equity and bond markets continue to be terrified of the big, bad Fed.
That’s been the case for decades, certainly since Chairman “Tall Paul” Volcker raised the federal funds rate to 19% in 1980 and caused a recession. It demonstrates the sheer power the central bank has over the markets.
The question is this: Should investors really be this intimidated by Powell & Co.?
After all, the economy remains strong despite the fact that the Fed has raised rates by 4.75 percentage points over the last 12 months, one of the most dramatic hiking cycles in U.S. history.
The economy added more than 300,000 new jobs in February. The unemployment rate remains low, at 3.6%.
And GDP grew at a respectable 2.7% in the fourth quarter after increasing 3.2% in the third quarter of last year.
Clearly, the Fed’s rate hikes are not putting a major dent into economic growth. And despite all the warnings, there is still no sign of an imminent recession this year.
Sure, higher interest rates will increase bond yields. That could put some downward pressure on stocks as bond prices become more attractive. Higher rates will also make corporate borrowing more expensive and will cut into corporate earnings.
But those are short-term issues. Well-run companies with competitive advantages (the kind that our strategists here at The Oxford Club recommend) are not delicate enough to live and die on slightly higher interest rates.
Another question I have is this: Are higher short-term rates – the Fed’s primary tool – really the right measure to address the causes of the inflation we’ve been seeing for over a year?
What About the Eggs?
We’ve been hearing a lot about the 70% increase in the price of eggs. But that was caused by the bird flu.
Can a higher federal funds rate address that issue?
Energy prices are up worldwide. But that’s largely due to the Russian invasion of Ukraine.
Does Vladimir Putin care what the Fed does?
How about semiconductor shortages, which sent the prices of new cars soaring last year? Chips were scarce because of global supply chain issues.
The Fed’s rate hikes can only impact demand and will do nothing to ease supply bottlenecks.
Finally, a shortage of workers has driven prices up in many industries, particularly services.
Damping economic growth – which is what higher rates are intended to do – will not bring workers back into the labor force.
These supply-side factors will dissipate in different ways, all of which are largely disconnected from interest rates.
Smart investors know that. Hopefully the Fed will soon catch on.