Where is The Fed Taking Us?
There are three parts to the Federal Reserve System: the Board of Governors, the Federal Open Market Committee (FOMC) and the 12 Federal Reserve Banks. The FOMC architects monetary policy, including deciding the Federal Funds target rate and Prime rate.
Research shows that FOMC statements exert economically large and significant pressure on bond values. On days when the FOMC releases its minutes, the two and 10-year maturities of the U.S. Government bond have three to four times their average volatility compared to other days.
Simply put, the Fed moves the market and carries a lot of weight.
The State of Inflation
On Friday, November 4, at 5:30 a.m., the non-farm payrolls report was released, rising 261,000. (Yes – I was awake, having coffee on the couch next to my wife, Melissa. No – she didn’t care!)
I was interested because, in my mind, it’s the pace of acceleration or deceleration that is important.
The payroll number mattered because it provides perspective on consumers’ ability to make purchases. Similar to the CPI number released Thursday the 10th.
On November 1, 2022, the U.S. Department of the Treasury announced that Series I bonds will pay 6.89% annual interest through April 2023, a drop from the 9.62% yearly rate offered between May and October.
Why? One possible answer is that the pace of inflationary pressure is easing.
The Series I rate combines a fixed rate, which remains the same throughout the bond’s life, and a variable inflation rate that the Treasury adjusts every six months based on the change in the consumer price index (CPI).
Below is a breakdown of what the CPI measures and each category’s weighted average. Additionally the table shows the annualized change in Headline and Core CPI, not seasonally adjusted for each of the past six months. To go super nerdy – Food and Energy are removed from Headline, leaving Core.
CPI Component Weightings:
Source: Advisor Perspectives
To calculate housing costs, the Bureau of Labor and Statistics (BLS) counts cash rent paid to the landlord for shelter and any utilities included in the lease, plus any government subsidies paid to the landlord on the tenant’s behalf.
If the owners occupy a housing unit, the BLS computes what it would cost the owner to rent a similar place, known as Owners’ Equivalent Rent (OER). The cost of utilities paid by homeowners is measured separately in the CPI.
The Outlook for Housing Costs
Housing represents more than a third of the value of goods and services that the BLS uses to calculate the CPI. As a result, it plays a key role in assessing how inflation is trending — and the efficacy of the Fed’s approach.
So, where might housing costs be headed?
Zillow’s recent “Rental Market Trends” report suggests that rental rates may be rolling over. Furthermore, in a recent opinion piece for the New York Times, Robert Shiller, a credible and noteworthy voice in the industry, argued that “real (inflation-adjusted) home prices will likely be a lot lower in a few years, but this is not certain.”
Consider the lending environment and month-over-month or year-over-year mortgage rate comparisons to gauge homeowner expenses.
At Spartan’s recent First Friday Meetup, I spoke with a mortgage lender who shared that banks base a typical 30-year mortgage rate on the 10-year U.S. government bond’s yield. A year ago, they would add one and a half percentage points for a risk premium on top of the base lending rate. Today, banks are adding a three percent risk premium to the base lending rate. In other words, the expense is higher.
However, if we have a recession in 2023, the yield curve will likely adjust similarly to how it did when the recession and COVID-19 hit in 2020. En masse, bond yields fell across the board as capital flowed into the safety of bonds, pushing bond prices up and the yield curve lower.
It is important to note that many economists agree that it takes 18 months for the full effect of a federal funds rate increase to be felt in the economy. But, as a leading indicator of economic activity, the stock market is unlikely to wait that long to price it in.
The Spartan Perspective
Depending on your base case for the economy, we may soon see inflationary pressures begin to subside.
If the economy slows, unemployment will rise. Fewer people in work will reduce pressure on the housing market and other parts of the economy. Capital may continue to leave the stock market and move into bonds, and the yield curve may reshape, taking some of the heat out of inflation (specifically housing).
Conversely, if the economy accelerates, we will see continued pressure on housing prices and energy, increasing inflationary pressure in other areas of the economy. This may cause the Fed to continue to raise the federal funds rate in an attempt to reach its two percent inflation rate goal.
This economic indicators calendar breaks down upcoming dates of key economic data releases, which may provide additional insight into the state of the economy.
Earlier I described the exciting lifestyle led by my wife and me by way of nail biting CPI news releases consumed leisurely while most sane people are otherwise occupied, and how the trend is important.
Let me draw your attention to the below charts. These are offered by CME Group and are found here by scrolling down and clicking on the probabilities tab. These charts speak to the expected elevation of the Fed Funds rate in the future. Accordingly, as of November 4 (stale information yes, but it’s the trend that I want to draw attention to) the market thought that there was a mid 30% likelihood that the Fed Funds rate would be priced between 5% and 5.25% for much of 2023. Contrast that former perspective with the market’s recent perspective (as of November 10) that the peak in the Fed Funds rate will be 4.75% – 5.00% and begin to move lower sooner.
Importantly, these figures were captured at two different points in time.
This chart is from November 4, 2022
This chart is from November 10, 2022
The trend over the last week paints a picture of inflationary pressures easing in the future.
If you are adjusting your investment policy due to current events, a best practice is to optimize your portfolio such that no matter what happens, you end up in a place you’re comfortable with.
If you are interested in discussing how an investment with Spartan may be impacted by various economic outcomes, schedule a call with me.
Published by Ted Greene