Don’t Fight the Fed
In 2022, the news is full of economic stories. Topics like interest rate hikes, inflation, the federal reserve, and many more are frequently mentioned in headlines and articles. Media outlets know these topics have a far-reaching impact, but what does mean for you? How did we get here? Please read along as I discuss several key financial events from 2022.
The Federal Reserve, more specifically the Federal Open Market Committee (FOMC), began increasing interest rates this year in March. This was the first interest rate increase since 2018. The first increase this year was 0.25%, which moved the Fed Funds rate from a range of 0 to .25% to a range of 0.25% to 0.50%. This 0.25% increase in March was followed by a 0.50% increase in May, a 0.75% increase in June, and a 0.75% increase in July. The latest rate increase in September 2022 of 0.75% puts the Fed Funds rate at 3.00 to 3.25%. The next Fed meeting is slated for November 2nd, and another increase is expected then.
These increases have created a problem in the bond market, as the US bond aggerate has dropped -14.86% as of 09/26/2022. If you are looking to borrow, interest rates increase almost as quickly. A thirty-year fixed mortgage hit 6.74% on 09/27/2022. Compare this to the start of the year when it was 3.25%. In less than nine months, we have moved from a period of low borrowing rates and declining interest rates to a period of increasing interest rates and increasing borrowing costs.
This rapid deceleration of the economy is comparable to driving 80 miles an hour on the highway, and slamming on the brakes because you see a car stopped alongside the road and want to look. The Fed Funds rate increase is intended to slow an economy that is expanding faster than goods and services can keep up. And this is on top of the effects of COVID supply chain issues.
When we look at the issues that caused the increased economic activity over the last year, most of those issues are over. The government stimulus checks that were handed out and the COVID shutdowns are now things of the past. Supply chain issues are still working themselves out, but the number of ships waiting to unload at ports is now near normal levels. The costs to ship goods from China to the US are coming down from their peak, but they are still above 2019 levels. Other input costs are also coming down, like steel and oil.
While you have the Fed increasing interest rates, you also have them slowing their bond buying and starting to be a net seller of bonds this year, as they unwind their balance sheet. During the pandemic, you may remember the Fed buying bonds and mortgages to increase the amount of money in circulation. Therefore, more money in circulation adds to inflation. Unlike Quantitative Easing (QE) when the Fed buys bonds and in injecting cash into the economy, we now have Quantitative Tightening(QT), with the Fed taking money out of circulation, and placing additional pressure on bonds and the economy as a whole.
If the Fed’s history of fighting inflation continues, the Fed rate hikes will stop once the Fed rate is higher than Consumer Price Index (CPI) inflation number. Given that CPI is currently around 9.10% and it is expected to start going down, the Fed has a way to go with a current expectation that Fed Funds could top out 5% sometime next year. The current Fed dot plot shows a peak Fed Funds rate at 4.60% at the end of 2023.
So, what can you do in a period like this? Well, don’t fight the Fed. Let them provide opportunities for you. Just like the car slamming on the breaks, the Fed will have to change course. Eventually, they will have to start lowering interest rates to restimulate an economy that has slammed to a stop. When this happens, this can be an opportunity to sell short-duration bonds you held while the Fed was tightening/raising interest rates and start to invest in longer-duration bonds. Duration is the number of years until a bond matures. It is also important to keep an eye on a bond’s credit quality. For your reference, the US bond aggerate can be tracked using iShares ETF AGG. The ETF AGG is a high-quality moderate duration bond ETF.
In economic conditions such as these, it is important to remain patient, stay the course, and keep your money invested. For example, a stock price may decrease, but its dividend may increase. Staying in the market allows investors to take advantage of these dividends and the eventual upturn of the stock market. On the bond side of things, the bond market will also positively respond when the Fed pivots its position.
Here at Stewardship Advisors, our team continues to monitor and adjust our client’s equity and fixed income allocations in response to future economic conditions and the Federal Reserve outlook. If you would like to discuss this further, please feel free to give our office a call.
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