The Federal Reserve’s aggressive interest rate hikes can only last for a while. The stock market may experience some relief soon enough.
Right now the Fed is pushing rates up. The central bank announced on Wednesday that it is raising the federal funds rate by three-quarters of a percentage point and expects it to rise to 3.75% by the end of 2023. It is trying to slow inflation which remained high.
It’s scary at the moment, but it won’t be long before the hikes slow down considerably. The Fed’s forecast for the end of next year implies that it will raise rates several times this year, then raise them only a few times next year. By 2024, the federal funds rate would fall back to 3.5%, according to most Fed members’ projections. This “suggests that rate cuts will be a reality within two years,” wrote Ian Lyngen, head of US rates strategy at BMO.
It’s not just these projections, but rates across the bond market reflect that the economy will need lower rates down the road. It starts with government bond yields, as rising fed funds rates push them higher. This pushes corporate and household bond rates higher. This is because bond investors demand a higher yield on corporate and personal bonds than on government bonds because companies and individuals may not repay their debt. Moreover, the yield spread between these bonds and government bonds – or the spread – has increased. Investors are demanding a particularly high yield on, say, corporate bonds in return for the increased risk that corporate earnings will head down, making defaults more likely.
Now, average yields on triple-B-rated corporate bonds are nearly 2 percentage points higher than comparable government bond yields, according to Morgan Stanley. That’s about double the spread of almost 1 percentage point at the pandemic-era low. Historically, when spreads rise, they often precede a lower fed funds rate. The idea is that the bond market is signaling that the economy will eventually need the Fed to cut rates.
Consistent with this, economists expect demand and inflation to slow in the coming quarters. The consensus among economists is that increases in the consumer price index will slow over the next few years, starting in the second half of this year, according to FactSet.
Already, very early signs of a slowdown in demand and inflation are appearing. Admittedly, inflation is slow to slow, fueling fears that the Fed will remain more aggressive than expected. But
(TGT) recently said it was cutting prices on some discretionary goods because it had too much for the level of demand. And speaking of spending on goods, actual retail sales are down. This recently reached just over $500 billion per year, according to 22V Research. That’s below the overall pandemic-era trend of nearly $650 billion and down from just over $600 billion at the start of 2021. That means consumers are buying fewer “things “. When “real” spending falls, it means that higher prices induce people to reduce the number of goods they buy.
This slowdown in demand and inflation could ultimately be good for equities. The
is already down 23% from its all-time high in January, reflecting the risk that higher rates will hurt economic growth and corporate earnings. So if the economy avoids total disaster, then stabilizing or lowering rates would spur a market rebound. Some technical market trends are already pointing to stock market gains for about the next year. There might just be more pain in the very short term first.
“If the Fed is right and inflation…corrects in 2023, then the end of the equity decline is much closer to the finish line than the starting line (but we can’t yet say the bottom is reached),” Tom wrote. Essaye, founder of Sevens Report Research.
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