All eyes remain on the Federal Reserve this year as the Fed’s fight with inflation continues to have a large effect on financial markets. Global stock and bond markets continue to struggle this year as the Fed front-loaded rate hikes in an aggressive manner by increasing the Fed Funds rate by 0.75% in each of their last three meetings. The Fed Funds rate is now between 3.00-3.25% with projections that they could increase to 4.50% or above by the end of the year. The stock market has attempted to rally a few times in anticipation that the Fed may be getting closer to the end of their rate hike cycle. However, the Federal Reserve has quickly come out with more aggressive policy rhetoric, which caused these rallies to reverse.
The Federal Reserve continues to highlight their desire for a more restrictive policy stance until they have seen a meaningful and sustainable reduction in inflation. It seems as if the Fed is attempting to keep markets down until they feel they have inflation under control, for fear that a rebound in markets would increase consumer spending and go against their ability to reduce inflation. The Fed does not have control over the supply side of the economy so in order to bring down inflation; they are trying to reduce demand by making borrowing more expensive and tightening financial conditions. The Fed’s tools for fighting inflation have been described as blunt force instruments that cause many disruptions in markets.
The cost of borrowing has increased dramatically this year with 30-year mortgage rates approaching 7% after starting the year slightly above 3%. The same is true for business loans, auto loans, and credit card interest rates. As the Fed increases the Fed Funds rate, these increases trickle through the lending system causing higher borrowing costs. The Fed’s goal is to try to motivate businesses and consumers to reduce spending in order for demand to come down. The Fed would also like to see less job openings and more job seekers in order to bring the labor market into balance. The Fed does not want to see wage pressures continue to build since this also goes against their goal of reducing inflation back to more normal levels. As wage pressures build, companies increase prices to offset these additional costs, which adds to inflation.
The U.S. economy contracted in both the first and second quarter this year, and is projected to show only slightly positive gains for the remainder of the year. So far, US company earnings have remained fairly strong as companies pass on higher costs to consumers. The job market continues to remain hot and unemployment figures are low which is helping to keep the economy from tipping into a recession as consumer spending remains robust. The Federal Reserve is in a difficult position as they try to slow the economy to reduce inflation, without tightening conditions too much to cause a recession. The probability remains elevated for a potential recession by the end of 2024, however many deciding factors will be in play going forward.
The stock market usually bottoms well before the economy so while economic conditions may continue to slow for the near future, we will look for clues that inflation has peaked and begins to subside indicating the Fed is winning its battle. We are mindful of the risks that the market faces going forward from a more aggressive Federal Reserve, elevated inflation, continued supply chain issues, and ongoing geo-political risks. We recommend staying the course with your investment objectives with the understanding that markets go through cycles and both the stock and bond market will eventually find their footing. It is important to communicate with us if any short-term cash needs arise so we can look for opportunities to be proactive when raising cash for those distributions, helping to protect against possible short-term negative moves in the market.