Focus on the Fed

After a strong first half of the year, increased concerns that interest rates will continue to climb caused markets to fall during the third quarter. Stocks, after starting a new bull market early this year, neared correction territory in September. Bonds have been drifting lower as interest rates have slowly and consistently moved higher. Rising energy prices have stoked fears about inflation, and with the Federal Reserve hyper focused on the inflation rate, most economists are now expecting interest rates to stay high longer than initially thought. GDP is expected to rise over 4% during the third quarter, which is amazing given the current level of interest rates.  It looks like we’re in for a bumpy ride.

We have spoken at length in past letters about the inverted yield curve. This doesn’t happen often, but when it does, it almost always foretells a recession. The current inversion is the longest and deepest inversion since the early 1980’s. While many analysts and economists have stepped back from their recession predictions, the fact remains that we are at an elevated risk of recession, and the deeply inverted yield curve cannot be ignored.

We are often asked why higher interest rates make the markets go down. Increasing interest rates hurt both stocks and bonds, but in different ways. With bonds, it’s a matter of simple math. As rates move higher, existing bonds become less attractive relative to newer bonds. Movements in bond prices as rates change are easily calculated. Duration and convexity tell us how much bond prices will rise or fall with changes in rates. When rates rise, bond prices drop, and when rates drop, bond prices rise.  This relationship never changes.

Rising interest rates hurt stocks in several ways. Appropriate valuation calculations for stocks are usually done through models that use short term rates to discount cash flows. As rates rise, valuations drop. Higher interest rates also make safer investments like bonds more attractive relative to stocks. Also, high rates slow economic activity, leading to lower profits for businesses, thus dropping stock prices.

The Federal Reserve has a very difficult job. They are charged with keeping the economy growing while doing it with low inflation. They have been mostly successful at this for forty years. They had some missteps coming out of the pandemic but that was a unique set of circumstances. It will be interesting to see how history judges them.

Over the next twelve months we could very well see energy prices drop along with inflation. This would likely lead to strong rallies in both stocks and bonds. If the Fed achieves their soft landing, consumers and investors will benefit. Until then, we, like everyone, will be watching the Fed.

Wabash Capital