Timing the market has been a nagging question for investors ever since the stock market began its decline by roughly 25% in January this year. The right answer likely hinges on whether or not the Federal Reserve follows through with plans to raise its benchmark interest rate to 4.5% or higher next year.
Global markets are on edge about the possibility of an emerging-markets crisis resulting from higher interest rates and a U.S. dollar at a 20 year high, or a slump in the housing market due to rising mortgage rates, or the collapse of a financial institution due to the worst bond market in a generation. So questions about the Fed’s ability to pull off its planned interest-rate hikes to tame inflation without forcing the economy into recession have whipsawed markets almost on a daily basis.
Still, assuming the Fed succeeds and effects a policy pivot when a financial stability crisis occurs or inflation peaks or, the case for buying stocks remains sound — in the next year or so, according to two market analysts.
The problem is that continued market volatility makes it difficult to ascertain when markets might offer buying opportunities, said Bill Sterling, the global strategist at GW&K Investment Management.
The peak in interest rates matters for stocks
Historical market data can give investors a good reason to be skeptical about the credibility of the Fed’s forecasts while market based expectations captured by the Fed funds futures markets and bond yields may be no more reliable.
Dating back to August 1984, the S&P 500 index
SPX,
has risen on average more than 17% in the 12 months (see chart) that followed a peak in the Fed funds rate range, according to Sterling at GW&K and Fed data.
FEDERAL RESERVE, FACTSET
The chart also shows the Nasdaq Composite COMP and Dow Jones Industrial Average DJIA rose sharply in the year after the Fed’s brought interest rates to their peak levels in prior monetary policy tightening cycles over roughly the past 40 years.
The same holds true for bonds, which have historically outperformed after the Fed’s interest rate hiking-cycle reached its apex. Sterling said yields historically retreated by, on average, one-fifth of their value, in the 12 months after Fed benchmark rates peaked.
Still a factor that differentiates modern times from the persistent inflation of the 1980s is the elevated level of geopolitical and macro-economic uncertainty. As Tavi Costa, portfolio manager at Crescat Capital, said, the weakening U.S. economy, plus fears of a crisis breaking out somewhere in global markets, are complicating the outlook for monetary policy.
But as investors watch markets and economic data, Sterling said that “backward-looking” measures like the U.S. consumer-price index and the personal consumption expenditures index, aren’t nearly as helpful as “forward looking” gauges, like the breakeven spreads generated by Treasury inflation protected securities, or survey data like the University of Michigan inflation expectations indicator.
“The market is caught between these forward looking and encouraging signs that inflation could come off in the next year as seen in the {Treasury inflation protected securities] yields,” Sterling said.
So far this week, Minneapolis Fed President Neel Kashkari and Fed Governor Christopher Waller have said that the Fed has no intention of abandoning its interest-rate hiking plan, in what were only the latest round of hawkish comments made by senior Federal-Reserve officials.
However, some on Wall Street are paying less attention to the Fed and more attention to market-based indicators like Treasury spreads, relative moves in sovereign bond yields, and credit-default spreads, including those of Credit Suisse Inc.
CS,
Costa at Crescat Capital said he sees a growing “disconnect” between the state of markets and the Fed’s aggressive rhetoric, with the odds of a crash growing by the day and because of this, he’s waiting for “the other shoe to drop.”
He anticipates a blowup will finally force the Fed and other global central banks to back off their policy-tightening agenda, like the Bank of England did last month when it decided to inject billions of dollars of liquidity into the gilts market.
Tavi expects trading in fixed-income to become as disorderly as it was during the spring of 2020, when the Fed was forced to intervene to avert a bond market collapse at the onset of the coronavirus pandemic.
“Just look at the differential between Treasury yields compared with junk-bond yields. We have yet to see that spike driven by default risk, which is a sign of a totally dysfunctional market,” Tavi said.
See: Cracks in financial markets fuel debate on whether the next crisis is inevitable
A simple look in the rear-view mirror shows that the Fed’s plans for interest-rate hikes rarely pan out like the central bank expects. Take the last year for example.
The median projection for the level of the Fed funds rate in September 2021 was just 30 basis points one year ago, according to the Fed’s survey of projections. It was off by nearly three whole percentage points.
“Don’t take the Federal Reserve at its word when trying to anticipate the direction of Fed policy over the next year,” Sterling said.
Looking ahead to next week
Looking ahead to next week, investors will receive some more insight into the state of the U.S. economy, and, by extension, the Fed’s thinking.
U.S. inflation data will be front and center for markets next week, with the September consumer-price index due on Thursday. On Friday investors will receive an update from the University of Michigan’s on consumer sentiment survey and its inflation expectations survey.
What’s more, for the first time in months, investors are grappling with signs that the labor market may indeed be starting to weaken, according to Krishna Guha and Peter Williams, two U.S. economists at Evercore ISI.
The September jobs report on Friday showed the U.S. economy gained 263,000 jobs last month, with the unemployment rate falling to 3.55 to 3.7%, but job growth slowed from 537,000 in July, and 315, 000 in August.
But will inflation shows signs of peaking or slowing its rise ? Many fear that the crude oil production-quota cuts imposed by OPEC+ earlier this week could push prices higher later in the year.
Meanwhile, the Fed funds futures market, which allows investors to place bets on the pace of Fed interest rate hikes, anticipates another 75 basis-point rate hike on November 3.
Beyond that, traders expect the Fed funds rate will top out in February or March at 4.75%, according to the Fed’s FedWatch tool.
But if a Fed policy “pivot” does arrive investors should expect stocks to rocket higher in the fourth quarter. Ultimately, trying to anticipate when the peak in interest rates will actually arrive could be one way for investors to get rich by doubting the consensus.
The Nasdaq fell 3.8% on Friday, paring its week-to-date gain to just 0.7% as it finished the session at 10,652.40. Meanwhile, the Dow Jones Industrial Average
DJIA,
fell 2.1% on Friday, paring its weekly gain to just 2%, as it finished Friday’s session at 29,296.79.
