Tightening cycle closer to the end than the beginning
Stocks oscillated between gains and losses, and the 2-year Treasury yields briefly jumped above 4% in response to the Fed's hawkish projections, calling for more hikes ahead. The steeper rate path than the one officials projected in June highlights the Fed’s resolve to cool inflation and likely means further tightening in financial conditions, slower economic growth, and higher unemployment. Despite the renewed pressure in financial markets and the economy that the Fed's path implies, the decline in stocks and rise in bond yields experienced this year already largely reflect this challenging backdrop, in our view. And what might help the market find some footing is that the Fed's updated projections will make it harder for the Fed to be more hawkish than it is now.
Fed intends to keep rates higher for longer
The Fed delivered another three-quarter-point rate hike, its third in a row, raising the fed funds rate to a range of 3.0%-3.25%, as expected. The September hike pushes the policy rate into restrictive territory, above the 2.5% rate that policymakers consider neutral (neither stimulating nor constraining the economy), as the Fed wages its most aggressive fight against inflation in four decades. Along with its policy rate, the Fed released its updated economic projections, which showed another 1.00% - 1.25% of rate hikes this year (possibly 0.75% in November and 0.5% in December), and rates peaking at 4.6% in 2023. Officials also revised their forecasts for growth lower and for unemployment higher, as the economy is projected to slow further in response to the tightening of financial conditions.
Policy-rate expectations have continued to move higher, and as a result the 2-year Treasury yield sits at 4.0%, its highest since 2007, and the 10-year Treasury has moved past the 3.5%1. However, the silver lining is that the Fed now has some room to soften its tone if the data supports it down the road. It's possible that the recent easing in consumer inflation expectations and more signs of a global economic slowdown contributed to the Fed avoiding hiking by a full percentage point, even though markets assigned a small chance for that to happen.
Volatility likely to stay elevated until inflation peak is confirmed
Heading into the last quarter of the year, we think that inflation will be the No. 1 driver that will determine the direction of travel for the markets. Until a pattern of lower inflation readings is established (likely three or more needed), equities are going to have a hard time mounting a sustainable rebound. While the August CPI data move us a bit further away from the best-case scenario, it does not necessarily change the likelihood that the rate of inflation will slow in the coming months, driven by improved supply-and-demand dynamics. With the Fed firmly on the brakes and growth slowing, the macroeconomic backdrop remains challenging, requiring patience from investors. Markets might stay range-bound for a while but should eventually start recovering as central banks become less hawkish.
Keeping a long-term perspective can pay off
While we don’t think that volatility will be over soon, we believe that this year's market downturn presents a compelling opportunity, depending on investors' risk tolerance and time horizons. A focus on quality and defensive positioning is warranted in the short term, in our view, as the Fed's tightening will continue to pose a strong headwind to growth in the coming quarters. But with equity-market valuations having come down about 26% and with a sizable amount of recession fear priced in, we are likely closer to a bottoming process today. Long-term investors should consider the following:
- The average bear market since World War II has lasted about 11 months2. At nine months, the current bear might be maturing, especially if inflation starts to moderate, allowing the Fed to pause. Looking past the valley, bull markets, on average, last nearly five years, with an average gain of about 130%2.
- Generally, stocks are forward-looking and historically tend to bottom before the economic data starts to improve, which is why bear markets historically have ended before the recessions have.
- While the daily swings in markets can be uncomfortable, sticking to one's investment plan is often the best approach. With the best- and worst-performing days often found near one another, getting in and out of the market can create missed opportunities. After all, compounding over time is the most powerful tool investors have when it comes to achieving long-term goals.
Source: FactSet, Edward Jones. Past performance does not guarantee future results.
The graph shows the effective fed funds rates along with market projections for a 4.5% peak in March of 2023. The 10-year Treasury yield has tended to peak a couple of months before the last Fed hike.
Angelo Kourkafas, CFA
Sources: 1. Bloomberg, 2. Bloomberg, Edward Jones
Angelo Kourkafas is responsible for analyzing market conditions, assessing economic trends and developing portfolio strategies and recommendations that help investors work toward their long-term financial goals.
He is a contributor to Edward Jones Market Insights and has been featured in The Wall Street Journal, CNBC, FORTUNE magazine, Marketwatch, U.S. News & World Report, The Observer and the Financial Post.
Angelo graduated magna cum laude with a bachelor’s degree in business administration from Athens University of Economics and Business in Greece and received an MBA with concentrations in finance and investments from Minnesota State University.
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