Market Gets Ahead of the Fed
Quick Take: Equity and bond markets started the year strong after a rough 2022 as the market believed the Fed will cut rates this year, despite denials from the Fed.
January logged a strong month of gains, with the S&P 500 closing up 6.2%, while the Nasdaq surged 10.7% for its largest increase in January since 2001. Expectations that interest rates are nearing a peak have fueled growth stocks with higher growth potential.
Since its October low, the S&P 500 has staged a rally of 11%, mostly based on market speculation that the Federal Reserve will shift from rate increases to cuts this year. Government bonds have also recovered some of their losses from a rough 2022, with the 10-year Treasury yield trading around 3.5% compared to an October peak of 4.231%. Bond prices rise when yields fall.
Even in light of mounting evidence of an economic slowdown, investors are rewarding companies that beat expectations while showing mercy to those falling short. This may be due to restructuring plans and cost-cutting initiatives, including broad layoffs, that generate investor confidence.
A New Bond Cycle
Despite the Federal Reserve’s (Fed) stance that it’s too soon to consider cutting interest rates this year, investors have grown increasingly certain that a rate cut will occur. The divergence has led to a growing disconnect between where the bond market predicts interest rates are going versus where Fed officials say they’re going. Market bets show the federal funds rate reaching 4.9% by June with two rate cuts in the second half of 2023. Meanwhile, Fed officials expect rates to reach 5.1% without rate cuts this year.
According to bond veteran and DoubleLine Capital’s chief executive Jeffrey Gundlach, investors should look at what the market is saying over what the Fed says.
Fed rhetoric is just as important as its actual policy moves. If the Fed says that inflation is no longer an issue, markets could surge and financial conditions might ease, making the Fed’s job of lowering inflation harder.
Monetary policy decisions hinge on inflation levels not only of goods and services, but also crucially of wage growth. For goods and services, the Labor Department has reported six consecutive months of decline in the Consumer Price Index(CPI). CPI rose 6.5% year over year in December – marking its slowest growth since October 2021. However, with the unemployment rate at a half-century low of 3.5% in December, the Fed is worried about an overheated labor market that risks fueling inflation.
Markets found relief that wage growth also has been decelerating, running at a 4% annualized rate in the 4th quarter of 2022, well below the 5.8% level reached early in 2022. The key question is whether the Fed’s target inflation rate of 2% can be reached. If not, rates may need to stay higher for longer.
Interest Rates Remain High
With the aggressive pace of Fed rate hikes last year, bond markets experienced a dramatic shift. PIMCO notes that in contrast to a year ago when yields were nearly-zero, bond markets are now offering the highest yields and total return potential in years.
Even adjusting for inflation, we haven’t seen real interest rates this high since the 2008 financial crisis. At the same time, uncertainty around economic growth, inflation and geopolitical tensions is likely to remain elevated in the near term—fueling ongoing market volatility and providing fertile ground for active managers.
Debt Ceiling Negotiations
In January, U.S. Treasury Secretary Janet Yellen announced that the country has reached its $31.4 trillion federal debt ceiling. To continue to fund any difference between spending and taxes, the government needs to raise that limit.
Reaching the debt limit has set off a contentious political disagreement that if unresolved, could threaten the stability of the global financial system. A group of Republicans in the House of Representatives is pushing for President Biden to agree to spending cuts before the debt limit can be increased, but the White House maintains that the debt ceiling should not be linked to any other actions. This has resulted in a stalemate.
Congress and the White House have until at least June to resolve the issue. The consequences of a U.S. default on debt would be disastrous on many levels – impacting the credibility of the US and its future ability to borrow.
The debt ceiling has been amended 78 times since 1960, but the threat to use it as leverage often goes down to the wire, possibly leading to government shutdowns and missed Social Security payments along the way. While a default is unlikely, markets would welcome less political theater.
New Year, New Direction?
The market appears to be starting 2023 with a few consensus calls – one such outlook is that we’re heading for a recession and the Fed is going to have to cut rates this year. Exercise caution with any predictions you come across – the market has a habit of behaving in ways that don’t necessarily match expectations.
Form 1099’s will continue to be released this month. If you have any questions regarding tax filing or the like, now is the time schedule a meeting with us and/or your accountant.
In our experience, meeting long-term objectives in the face of uncertainty requires patience and discipline. However, committing to a strategic approach doesn’t always come naturally, which is why we work with you to carefully craft a plan. Revisiting the plan as circumstances shift is also important, so don’t hesitate to reach out with any questions, thoughts, or concerns. Please remember to contact us if your financial circumstances have changed.
If you haven’t had a new year meeting with us yet, please reach out so we can put something on calendar! We would love to catch up with you and hear about any recent life updates. We appreciate your continued trust and confidence.
Your Friends at JSF
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The Bloomberg Barclays U.S. Aggregate Bond Index measures the investment-grade U.S. dollar-denominated, fixed-rate taxable bond market and includes Treasury securities, government-related and corporate securities, mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities.
The S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market.
The Nasdaq Composite is a market-capitalization-weighted index consisting of all Nasdaq Stock Exchange listed stocks that are not derivatives, preferred shares, funds, exchange-traded funds or debenture securities.
Treasury Bond- is a U.S. government debt security with a fixed interest rate and maturity between two and 10 years.
Gross domestic product (GDP) is a monetary measure of the market value of all the final goods and services produced in a specific time period. GDP is the most commonly used measure of economic activity.
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