By Kelvin Lee, Alonso Munoz
The Federal Reserve raised rates by another historic 75bps last week. That’s the third time this year and pushes the federal funds rate to a 3-3.5% target. As anticipated, equities have reacted negatively, and bond yields have spiked. The market is now pricing our earlier call of a 4.5-5 percent fed funds rate and stepping away from the idea that we’re going to keep a 3 handle on rates going into 2023. The last time rates were raised above 4% was 2007, a year before the infamous Great Financial Crisis.
Why is the Fed moving so fast?
On Wednesday’s press conference, Jerome Powell was more than sufficiently hawkish, borrowing words from his predecessor Paul Volcker.
“What we think we need to do and should do is to move our policy rate to a restrictive level that’s restrictive enough to bring inflation down to 2 percent … But we’re not at that level, clearly today we’re just, we’ve just moved I think probably into the very lowest level of what might be restrictive and certainly in my view and the view of the Committee, there’s a way to go.”
Ouch. Those aren’t the words you want to hear with mortgage rates above 6%, the S&P500 down 20%, and bond aggregate index down 12%. But the fed doesn’t view their decisions from the investor’s perspective. Their dual mandate is price stability and employment, and they only have blunt instruments to reduce demand to accomplish this. They will make their choices based solely on economic data, and the last Core CPI print and strong employment number tells them to keep hiking. That means they’ll have their blinders on for market participants until they get inflation, which is exceptionally sticky, below 3%. Come hell or high water, the central bank will (try) get inflation down.
The consequences?
A few problems with moving so much intro restrictive territory. First, timing. Because they want to get inflation under control quickly, they want to raise rates quickly. The velocity of tightening can be just as problematic as the severity. Because of the lag effect in monetary policy, we don’t really have the full results and effects on inflation from the prior rate hikes. That’s the biggest fear on the street, the fed risks going overtightening and deepening the recession.
Liquidity. Most investors, including us, take this concept for granted. Markets are supposed to always function, aren’t they? During March 2020 (Covid Crash), financial markets were on pace to systematically collapse. Not necessarily because companies were going to disappear, but mainly because the “pipes” or liquidity in the system was quickly clogging. In other words, the balance of buyers and sellers was dominated almost exclusively by the sellers. This caused the markets to fall too rapidly and caused emergency circuit breakers to trigger brakes in the trading days. We knew things were getting out of control when thirty-day U.S. treasury bills were trading at a premium above par, and short-term yields turned negative. At that point, overwhelming fear was snowballing into a full-blown financial crisis with unprecedented consequences. As usual, the Federal Reserve stepped in to save the markets with trillions of dollars in liquidity. Not billions…trillions. We all know what followed. As of today, the Fed has taken an overly aggressive stance, and risk another liquidity crisis and debt trap. To date, the sell-off has been relatively orderly, however another few aggressive hikes, combined with a recessionary environment and persistent inflation, could cause markets to panic and liquidity to dry up. This will force the Fed back into a rate cutting policy agenda, and further complicating financial conditions. We expect continued volatility, however opportunities are starting to appear for long term investors.
To contact the author of this story:
Kelvin Lee at kelvin@hamiltoncapllc.com
To contact the editor responsible for this story:
Alonso Munoz at alonso@hamiltoncapllc.com
