Week of Sep 19, 2022

OPENING REMARKS:

{This opening remark was written after Tuesday’s market close and therefore, some of the events that occurred on September 19th and 20th are reflected in this opening remarks.}

The highlight of this week will be the Fed’s meeting on Wednesday, September 21, 2022, which quite rightfully has overshadowed all other events. The markets have been up and down slightly during the first two days of this week which was quite expected. As we have been indicating in our reports during the past two weeks, the small volatility was expected. However, the Fed’s decision tomorrow will have a more lasting impact on the market both in terms of direction and intensity.

Currently, it appears that the markets are assigning a 75% probability to 75 bps increase and a 25% probability to 100 bps increase. So, unless the Fed increases the policy rate by ~80 bps, any decision it makes will set the markets into motion. We will discuss each scenario below:

• If the Fed increases the federal reserve rate by 75 bps, it will cause the markets to rally. Because the current perception in the market is that not only the 75 bps increase is already priced in, but the probability of a 100 bps increase is also incorporated in valuations.
  Reasons in support of a 75 bps increase are:

  • Certain indicators in the markets are showing signs of weakness, specifically in manufacturing production and orders.

  • The housing market is softening

  • Given that the quantitative tightening is rolling over concurrently with the impact that is partially unknown, the Fed might want to keep the markets calm with an increase that is already priced in.

    [update: see below for the discussion on the reasons as to why the 75 bps increase caused markets to slide and there was no immediate rally]

• If the Fed increases the federal reserve rate by 100 bps, it will send a firm message to the markets that the Fed is determined about cooling down the economy. That will cause a selloff in the market. In case of a 100 bps increase, we estimate that over a few days there will be around a 5% correction in the market.
  Reasons in support of a 100 bps increase are :

  • During the meeting in Jackson Hole, almost all of the FOMC members indicated that they prefer to frontload the rate hikes. This supports the 100 bps increase.

  • An increase in 75 bps, even if accompanied by strong hawkish rhetoric, will still send a message to the markets that the Fed is not as tough as it pretends to be and when the time comes, they will blink and will reduce the rates.

  • Increasing the rates when both consumers’ and corporations’ balance sheet is strong is definitely preferred to increasing rates two months down the road when the financial conditions are not as favorable.

At GGC, we are betting on a 100 bps increase, as we think that the Fed is serious about fighting inflation and if that is the case, it’s much better to send a shock to markets sooner rather than later. Any indication that the Fed is not serious about fighting inflation will cause markets to rally, which in turn will fuel inflation and make fighting inflation even harder down the road.

[Update: Wed, Sep 21, 2022]
The Fed raised the federal fund rate by 75 bps to a range of 3.00% to 3.25%. Click here for the release.
The Fed also raised its inflation outlook to 5.4% in 2022.
FOMC participant’s assessment of appropriate monetary policy was as follows:
- for 2022, the majority were between 4% and 4.5%;
- for 2023, the majority were between 4.25% and 5%;
- for 2024, it was widely spread between 4.75% to 2.5%.
Given that after this 75bps hike we’re at the 3%-3.25% target range, in order to get to the 4%-4.5% rate would require a combination of 75bps in November and 50bps in December. The higher rates in 2023 mean two more rate hikes in 2023, which the market had not priced in. Therefore, even though the Fed did not raise the rates by 100bps, the tone and the forward guidance indicated that there are outsized rate hikes in 2022 with two smaller rate hikes in 2023. During the past few months, the Fed indicated that they will not provide forward guidance. However, they did provide some guidance for future rate hikes, which resulted in market reaction.

Chairman Powell’s tone was hawkish with reference to ‘slow economic growth’ and ‘economic pain’ ahead. He also pointed to the current high employment rate and the fact that unemployment might rise as the Fed is fighting inflation.

Commentary:
Prior to the announcement, we were expecting that markets to rally in response to 75 bps increase. But that did not happen. The reason was the forward guidance that showed the forward path (at least based on the current available information) for the rate hikes in 2022 and in 2023. At a minimum, the 2023 rate hikes were not incorporated. In fact, during the past decade, one important aspect of the Fed’s operations was to clearly communicate a future guidance with the markets. During the past two meetings they indicated that they will be data-dependant and will not provide forward guidance. But it turns out that they are providing one.

The reactions to the Fed’s announce was mixed. Partially because the market was only expecting a rate, but more information came out with the rate that were significant. The trading day started by S&P 500 moving higher. Immediately after the announcement, prices dropped, then increased during the Q&A session with Jay Powell, and then again started to decline after the end of the meeting.

Although the 75 bps was already baked in the market prices, the new piece of information was the neutral rate which was higher than expected both for 2022 and 2023. In addition, the GDP growth forecast was lower than expected, combined with the fact that the Fed was okay with slower growth (and possibly recession, although they did not say that).

Dollar Strength

During the first two days of the week, we saw the dollar strengthening against all other major currencies. Depending on the quantum of the rate hike tomorrow, it is possible that the dollar becomes even stronger. The US Dollar has been the strongest since 2002. Below is the chart going back to 2013 with 20-day moving average.

Source: WSJ

US Treasury Yields

The 2-year and 10-year yields have inched higher, passing the 3.9% and 3.5% thresholds, respectively. The yield curve is still inverted. See below the 3 year chart for 2-year and 10-year treasury notes.

Source: WSJ

Source: WSJ

Investment Strategy

We will create a separate post for investment strategy, but in light of many changes we’ve mentioned, you might ask so what should be our investment strategy? We recommend the following:

• US treasury bills with less than 2 years to maturity

• Investment grade corporate bonds with 1 or 2 years to maturity

• High dividend yield stocks of companies with strong balance sheet

We do not recommend buying high-yield bonds because the high-yield spreads are still not to the levels that they usually reach at the time of recession, and if we are getting into a recession, the spreads will widen.