Perhaps it is appropriate Groundhog Day is next week, because there was a distinct feeling of déjà vu this past week. Obviously, this is in reference to the movie of the same name in which the protagonist, Phil Connors, relives the same day over and over. No matter what he does to affect change, there is little to no difference to the day’s ultimate outcome. In essence, you could say “the more things change, the more they stay the same.”
Yep, that sums things up pretty nicely, but for one exception: the Federal Open Market Committee (FOMC) meeting which ended around lunch on Wednesday.
As a point of elucidation, the FOMC (Fed) is the policy making arm of the Federal Reserve. For weeks, the markets had been expecting the Fed to telegraph any upcoming rate hikes and give a better indication of just how tight future monetary policy will be. What is the Fed going to do? Inquiring minds wanted to know; needed to know.
Anybody who has followed the Fed for any period of time knows it doesn’t like to “shock the markets” unless it feels it absolutely has to do so. What’s more, “emergency moves” are almost always rate cuts, not rate hikes. While I could be wrong, and from what I can tell, it has been some 28 years since the Fed shocked the markets with an interim (between scheduled meetings) rate HIKE. Regardless, the Fed almost never, if ever, embarks on a rate-tightening cycle out of the clear blue sky.
So, for all intents and purposes, the markets were on pins and needles waiting for an assurance the Fed was prepared to raise the overnight lending target and, if so, the associated timing. After all, with 12-month inflation currently running at a 7.0% clip and Gross Domestic Product (GDP) growth of 5.7% in 2021, ‘we’ were arguably well past due for something to happen. How much longer could the Fed keep the overnight rate at 0.0-0.25% with inflation at the highest levels in some four decades? Indeed.
Fortunately, or unfortunately, the official statement from the meeting all but guaranteed the Fed is prepared to move at its next scheduled meeting on March 16, 2022. Here are the pertinent snippets from that document:
“With inflation well above 2 percent and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate. The Committee decided to continue to reduce the monthly pace of its net asset purchases, bringing them to an end in early March.”
To be sure, for casual conversation, this is pretty arcane, fuzzy, nebulous, you name it. However, I have been in this line of work for a little over three decades, and that is about as clear a message as I have ever seen in a Fed statement. The message being: “We are going to raise rates at the next meeting. Book it Dan-O.”
But what does this all mean, these higher interest rates? After all, the Fed has kept its proverbial foot on the gas pedal for so long. How do the economy and the markets function without gobs of liquidity sloshing about? How do we survive when the Fed takes its punch bowl away?
Oh…the wringing of hands and gnashing of teeth.
Let me be blunt: we would have more reason to worry if the Fed did NOT start raising the overnight lending target – – and soon. Inflation seems somewhat out of control; real interest rates are way negative, and the official Unemployment Rate is 3.9%. While the Fed might be able to argue the economy isn’t at full employment due to a worrisomely low Labor Force Participation Rate (61.9%), everyone who wants to have a job can get a job. As such, it would appear as though it is high time the Fed started focusing on “price stability.”
Even so, higher interest rates aren’t good for the markets or the economy, right? After all, interest rates are really nothing more than the price of money in the economy. So, higher interest rates mean more expensive money, right? So, how, or why, is this good?
Let me answer this by using a little analogy. Imagine you go out to dinner with a friend. You all order the most expensive meals on the menu and order a second bottle of the most expensive wine. I mean you really splurge. Then, they insist on picking up the meal. How do you like that? Pretty sweet, huh? Now, about the next time you go out, you all light it up again. This time, however, they ask you to pick up 10% of the tab. How do you respond to that turn of events? Are you livid beyond control? Turning over tables and knocking over chairs? Using the coarsest language to express your immense displeasure? Will you be wearing a barrel home?
Probably not. While no longer free, you still aren’t completely paying your way, meaning the evening out isn’t all that expensive to you. Am I right? However, how will this change your consumption patterns the next time you all hit the town? That is the $64,000 Question.
In case you haven’t guessed, this upcoming rate hike takes the free meal in the story to the only slightly less free one. Money is still going to be cheap, very cheap, and I mean exceedingly so. There will still be an enormous amount of excess liquidity in the financial system. Inflation will remain above the Fed’s 2% for a while longer yet. The yield curve isn’t going to invert any time soon, at least not without something extraneous happening. The Prime Rate will go from an all-time low to an almost all-time low. I think you get the picture.
As defined by the Fed Funds Target minus 12-month CPI (inflation), monetary policy is currently the loosest it has been in my life, not just my career. Keeping it as is, and pumping even more unnecessary liquidity into the system in the process, frankly, serves no purpose. No more so than serving a 600-lb. man an ice cream sundae in a bushel basket.
Fair enough, but what does it all mean? As with virtually everything else in life, the worst and best case scenarios almost never happen. Therefore, economic Armageddon is most certainly NOT on the horizon because the Fed raises the overnight rate a few times. However, the Fed IS taking the punch bowl away, and returns won’t come quite as easy as they have over the last 20+ months.
Therefore, as is usually the case, the truth lies someplace in between.
This means the likely outcomes will be a slowing in GDP from last year’s feverish 5.7% to something more normal like 3%, give or take a little. Interest rates and inflation will likely start to converge, at least somewhat, with the former creeping up a little and the latter falling some. Finally, it also means we shouldn’t expect the outsized returns the markets have produced over the last 3 years.
In essence, the low-hanging fruit is to predict some semblance of a return to normalcy in the markets. Please note I wrote the word semblance, as opposed to a complete return to normalcy. However, it will be a step in the right direction, and that is okay in my book.
As for how this all relates to Groundhog Day, well, it seems as though everyone has been predicting and hoping for a return to normalcy every day for the last two years, or more. Today is no different in that regard, and tomorrow won’t be either. As Yogi Berra was famed for saying: “it feels like déjà vu all over again.” In essence, you could say “the more things change, the more they stay the same.”
As always, I hope this newsletter finds you and your family well, and may your blessings outweigh your sorrows not only on this day but on every day (and don’t forget to listen to our Trading Perspectives podcast)!
As always, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our investment committee, is subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the rest of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.