Published July 7, 2023
There are a wide range of inputs portraying a change in investor attitudes over the past few weeks. Our friends at Delta Research offer one possibility of the change in how interest rates are viewed. We hope you find it interesting.
“The Federal Reserve raised the Fed Funds rate from 0%-0.25% to 5.00-5.25% since March of last year. The pace and amount of rate increases came as a surprise to most market strategists. The reason for the surprise is market strategists believed the economy would slow rapidly as a result of much higher interest rates. Coming into 2023, the market expectation was for one more rate hike, a pause and then rate cuts in the second half of the year. The Fed raised rates in March and May of this year and now is expected to raise again in July and then once again later in the year.
The Fed raises interest rates to slow economic activity for the purpose of reducing inflation. Higher rates act as a brake on consumption. Although the Fed is pumping the brakes harder than ever, the economy and consumers keep racing forward. According to ADP, private sector hiring increased by 497,000 jobs in June, twice the expected pace. Inflation currently is about twice as high as the Fed target rate of 2%.
Interest rates give us insight into economic expectations. When the Fed raises the Federal Funds rate, an overnight lending rate between banks, long-maturity rates like the 10-year treasury rate may decline. The long-dated interest rate (e.g., 10-year rate) reflects a blend of growth and inflation expectations. When the Fed raises short-term rates aggressively, the market expects both growth and inflation to subside.
On July 6, 2022, the 2-year treasury rate went above the 10-year rate. The yield curve inverted and has been inverted ever since. Inversion of the yield curve is a reliable indicator of recession.
A year has past since the inversion began and the economy is not in recession. Given recent economic strength, it appears unlikely the economy will go into recession this year. If there is no recession this year or next, it would be encouraging to see the yield curve regain a positive slope (10-year rate higher than 2-year rate).
Although the yield curve is as inverted as ever, we are beginning to see a path to a positive slope. Better growth has lifted the 10-year treasury rate from about 3.6% to 4.1% in the past several weeks. Growth appears to be the primary driver of the higher 10-year rate as inflation is expected to decline significantly in the next couple of months. For example, JPMorgan Asset Management is forecasting a June CPI of 3.2%, down from 4% in May. The Fed is telling us with their “dot-plot” rate forecast that they will migrate rates lower in 2024 and beyond to an eventual target of 2.5%. If economic growth continues and the Fed sticks to their rate forecast, the yield curve may regain a positive slope sometime next year.
A positive sloping yield curve combined with positive monthly Leading Economic Index (LEI) readings would be two reliable indications that the market advance since the October 2022 low may evolve into a multi-year bull market. We still have a ways to go before the yield curve un-inverts. In the next several months, it would not be a surprise to see the LEI turn positive.”
A quiet day in the markets Monday with light participation ahead of the July 4th holday. Stocks moved little with investors focused on the jobs reports due out later in the week. Returning Wednesday, investors saw stocks off a mere -0.2%. Minutes from the Fed’s most recent meeting affirmed expectations that the central bank will resume raising interest rates in their July meeting. The monthly ADP payroll survey came in way above forecast leading interest rates to take flight Thursday. Another report Thursday showed increasing growth in the service portion of the economy. The two economically strong reports pushed the 10-year yield above 4.0% which sent stocks lower. However, the market cut the losses in half by the close with investors buying the mid-day dip to leave the S&P 500 off -0.8%. The index had been down almost -2%. The Friday jobs report showed hiring down from the prior month, though the tight labor market continues to push wages higher as employers are forced to pay more to attract workers. Wages rose +4.4% over the prior year. Stocks spent the first half of Friday’s session with a positive reaction to the report before fading rapidly to end the day with modest losses. A sharp drop in the U.S. dollar sent oil prices higher fueling breakouts in the oil exploration and materials sectors.
Continued strength in the U.S. economy pushed interest rates notably higher this week leading stocks to pull back from their recent rally. The S&P 500 lost -1.07% on the week while the Nasdaq 100 (QQQ) dipped -0.86%. Smallcap stocks traded in a volatile fashion before closing the week down -1.25%.
Warm wishes and until next week.