IYY - The Fed Is Set To Tighten The Screws Further On The Economy

2023-05-01 15:40:11 ET

Summary

• The Fed is widely expected to hike interest rates by 0.25% to a range of 5.00%-5.25% at this week's FOMC meeting.
• This comes after three of the 30 largest banks in America have failed in the last two months.
• The stock market is all-in on a Fed pivot and has no respect for the Fed's inflation-fighting resolve.
• This further fuels inflation, leaving the Fed with no real choice but to hike interest rates again this week into worsening economic fundamentals, and probably in June as well.

After the FDIC seizure of First Republic Bank ( FRC ) over the weekend, three of the 30 largest banks in America have failed in the last two months. In past years, this would have led to the Fed immediately cutting interest rates to stave off a potential economic recession. However, with core inflation running near the highest levels in the last 40 years, the Fed is in a massive pickle. The problem is that while rate hikes are clearly causing economic pain, the stock market (and the American public in general) has zero respect for the Fed's resolve. The S&P 500 ( SPY ) is up about 9% this year while the NASDAQ ( QQQ ) is up nearly 22% on nothing but air. With S&P 500 earnings expected to be flat/down for the year , that's good for a PE ratio of 19.1x for the S&P 500 - with analysts assuming barely any economic slowdown at all. Meanwhile, the Fed is set to hike money market rates to 5.00%-5.25% this week. With interest rates above 5%, these are nosebleed valuations for stocks. Even if interest rates were near zero, these valuations would still be a little high compared with historical figures.

Put another way, you can now earn more in yield by parking your money in a Vanguard money market fund than you can by investing in the premier businesses in America at current valuations. Something eventually has to give, and as such, the Fed will jack up rates again at this week's meeting. And if nothing gives, they'll do it again in June, and again until the market gets the point.

The Fed Has No Real Choice But To Hike

Multiple Fed speakers have signaled their intention to hike rates by another 25 basis points this week to help bring inflation under control. Interest rate futures markets agree, pricing roughly a 90% chance of another hike at this week's meeting. The real money will be made or lost betting on the June meeting, however. Some more hawkish members of the Fed want to raise interest rates a few more times after May to hammer the coffin shut on inflation, while the more dovish members believe that the Fed should act now to limit the severity of the coming recession. The consensus is for one more hike now and maybe another in June.

As such, the market is now pricing about a 65-70% chance of a pause or cut in June, and about a 30-35% chance of more hikes.

However, where things get interesting is when you go out to January 2024. The market is pricing 3-4 rate cuts by January, while the Fed has signaled zero, even while acknowledging the probability of a hard landing in its forecasts . This is setting up a showdown between the Fed and the market, where the market is begging for a pivot and the Fed has determined that they'll keep rates high. Core CPI is still running at 5.6% annually.

Monetary policy is largely a game of expectations. If the Fed has credibility, a threat to raise rates can work to tighten financial conditions, carrying many of the benefits of actually hiking rates without actually having to follow through. However, if the Fed doesn't have credibility, then it takes far more brutal monetary policy to achieve the same effect. Higher stock prices in spite of worsening fundamentals tend to feed what's known as the " wealth effect " where consumers feel good about their stock balances and start spending and borrowing more. This fuels demand without creating any supply to meet it.

Right now, the Fed's credibility is badly damaged after claiming inflation would be "transitory" even as price increases spiraled out of control in 2021. To this point, they'll have to hike rates more than the market wants to regain control over consumer prices. Fed chair Paul Volcker famously raised rates to 20% in the early 1980s to shock the market into submission. The current Fed leadership would desperately like to avoid having to go this far, so raising rates by 25 bps this week and indicating another hike in June is likely the best course of action. If the market tanks and things suddenly tighten, they could rethink, but it's important that the Fed wrests control back from the market.

Should You Believe The Fed?

In this case, I would. Take the 5%-plus risk-free and wait for stocks to reprice. Allocating to cash paying over 5% is a totally different ballgame than allocating to cash paying 0%.

The stock market tends to operate mostly on sentiment, but historically, the bond market has an excellent track record of forecasting the economy. Right now, the bond market is forecasting significant economic weakness. However, as central banks got more and more involved in buying government bonds and mortgages, these price signals became increasingly distorted. To this point, what the bond market "thinks" is easily distorted by factors like the debt ceiling restricting the supply of short-term debt and the Fed's balance sheet. I prefer to take a more theoretical approach to what interest rates should be, because generally when either the Fed or the market goes against the theory, they get burned and are forced to correct course.

This should be familiar to my long-time readers, but I've used economic modeling based on the Taylor Rule to handicap where interest rates should be. Some features of the modeling include using core PCE inflation to avoid distortions, using an interest rate smoothing feature to allow for some aspects of inflation (about one-third) to be transitory, and using Okun's law for the output gap. It tracks well with actual Fed policy over time.

These models show that the Fed is still a little behind the curve, and as such should hike 1-2 more times. Running more iterations, there's some disagreement on how far to tighten, but no models are suggesting a cut or pause until there is significantly more slack in the labor market. Some models are suggesting a cash rate of 7% or more, which would be shocking for pivot-hungry bulls.

You should believe the Fed when they say they're hiking this week, and you should probably pencil in another hike in June unless things go seriously sideways for the economy. 6% is not out of the question if the economy keeps chugging along, and the Fed will be slow to pause/cut during the early stages of a recession as well. I get that it's not exciting to earn 5% to 5.5% annually in cash while people are making 20% in 3 months playing the Nasdaq. However, the past 25 years of history show that fighting the Fed is a futile struggle in the end. The Fed will hike until they inflict sufficient economic pain to bring inflation down and restore balance to the economy. This doesn't mean you can't or shouldn't buy stocks you think are a good value, but it does mean that the S&P 500 is broadly overpriced by 20% or more and that you can get paid nicely to wait for it to correct.

Bottom Line

Additional Fed hikes in May and June would take cash rates to 5.25%-5.5% and would start to put serious downward pressure on stocks as the market realizes that there will be no pivot without a sharp rise in unemployment. And with Republicans controlling Congress and Democrats in the White House, fiscal aid and bailouts will not be nearly as forthcoming as they were in 2020-2021. If student loan cancellation is blocked and debt ceiling negotiations reduce spending, this could be one of the larger fiscal "adjustments" in post-war American history. Free money isn't free, and stock valuations do matter. For these reasons, money market funds are by no means a bad place to be as the Fed gears up for another showdown with the market - even if your buddies are bragging about being up 20% for the year in tech stocks.

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