The Fed Will Subdue Inflation at Any Cost

Last week, in clear tones, Fed Chairman Jerome Powell said, “Inflation is running too hot. You don’t need to know much more than that.” He added, “This committee is committed to getting to a meaningful, restrictive stance of policy and staying there until we feel confident that inflation is coming down.” 

After hearing this, the bond market “took out” the stock market. Virtually all of the gains after the June bond rally had evaporated. The good news is that the S&P 500 retested its June lows on the final trading Friday of September, and it did not set a new low. However, trading volume was not near capitulation-selling levels, so additional retests may follow.

Powell called the Federal Open Market Committee’s commitment to fighting in-flation “unconditional,” and The Street takes that pledge at face value. The theme of this forecast is the Fed’s inflation-fighting resolve. The Fed’s latest forecast and Summary of Economic Projections show the median fed funds target at 4.4 percent this year, with its 2023 year-end median at 4.6 percent. To get to 4.4 percent, the Fed might hike 75 basis points in November and 50 more in December, which is entirely possible.

Last month was particularly tough for investors as all 11 S&P sectors experienced losses to some extent. As The Street expected, the market tested its June lows and set new lows in all major indexes to close the quarter.  

Not long ago, two-year Treasury rates rose above 4.3 percent, mortgage rates topped 7 percent, and 10-year Treasury rates rose above 3.95 percent as the bond market continued to spook the stock market. Mortgage rates hit their highest level in 20 years as the Federal Reserve has seemingly leaped from one extreme to the other, likely killing any remaining home-buying momentum. 

Housing now appears to be in a recession. Existing home sales were down 5.9 percent in July, or -25.9 percent since January! New home sales were down 12.6 percent in July, or -39.1 percent since December! What this means for lenders and the economy, both directly and indirectly, is another matter. Today’s housing market is so different from the past that it should be expected to behave very differently. 

From the 1960s through the ’90s, home sales typically peaked as much as a year before recessions and recovered before the economy recovered. This relationship broke down in the early 2000s when much of the industry abandoned rational mortgage lending standards. For a few years before the 2007/09 housing crash, anyone who wanted a loan could get a loan. Even subprime borrowers could borrow due to teaser rates. There was no housing correction during the 2001 recession because lending standards were easy enough to offset weakness in demand.

The S&P had shed almost 23 percent year to date before the strong market on Oct. 3 at least temporarily reversed market declines. Before Oct. 3, the market was within 10 points of last June’s low. This kind of price action still puts pressure on fund managers trying to put window dressing on their quarter-ending portfolios to show they have the right blend of risk and cash.

Cash levels now are at the extreme positions that have historically defined a market bottom, at least going back to the dot-com crash. The Bank of America Global Fund Manager Survey just revealed that cash levels reached 6.1 percent in August, the highest in 21 years.

One wonders what sort of headlines it might take to turn the long-term tide and bring confidence back to the market. It will probably take several headlines about inflation being on the decline, plus better-than-expected earnings from companies with market-leading stocks, as well as a change in the makeup of Congress after the November elections. Will the strong start to October continue?

With stocks in extremely oversold territory, a rally of perhaps 7 percent to 10 percent, hopefully, may be in the cards near term, and that would get the S&P back up to 4,000 (where the 50-day moving average lies overhead). If history is any guide, we’re about to be rewarded for our patience with a stronger market in the fourth quarter and well into 2023. However, that recovery still depends on what the Federal Reserve does next. 

And elections do matter, as well.