Fed Day Spurs Volatility

Here we go…Fed day. Volatility showed up in a big way, pushing the Dow down 522 points and the S&P down 1.7%. Treasury bonds swung hard the opposite direction, driving the iShares 20+ Year Treasury Bond ETF (TLT) up 1.7%. That’s a huge—and unexpected—move for bonds. WTI crude oil dropped 1% to trade at $83/barrel, the cheapest since January. Today’s policy announcement by the Federal Reserve was the obvious culprit, but the market’s reaction seems a bit knee-jerk.

As expected, the Federal Reserve’s key policy committee voted to raise the Fed-funds interest rate from 2.5% to 3.25%. This is the rate at which banks borrow from one another, and is used as a benchmark for all sorts of lending rates. What investors did not expect, however, was a combination of slower growth and higher interest rate forecasts for the near future. Prior guidance saw Fed-funds climbing to 4% by year-end, but today’s revision calls for 4.4%. In addition, real economic growth (excluding inflation) was seen at 1.6% this year vs. today’s revision down to .2%. In addition, the Fed expects inflation to remain stubbornly high, primarily because the labor market is so strong. The Fed’s goal is to slow hiring and consumer spending in order to take the wind out of inflation’s sails. All in all, this announcement was uber hawkish, with Chair Powell chanting repeatedly the Fed’s single-minded goal to kill inflation.

I think it’s more or less obvious that a lower growth and higher rate outlook would ding the stock market. But the bond market’s reaction is curious. In the run-up to this announcement, bonds have sold off, allowing yields to rise as it became clear that the Fed will continue to raise rates. But as I point out above, Treasury bonds reversed course and rallied hard today. Why? As Josh Brown, CEO of Ritholtz Wealth, puts it, “The bond market is already laughing at this.” What he means is that all of these threatened rate hikes won’t be necessary because higher rates and slowing growth will put the economy into the recession. And we all know that recession is a potent cure for inflation.

Put another way, investors are beginning to disagree with the Fed. A growing chorus of high profile money managers & economists say the Fed should now take more of a wait-and-see approach to raising rates, rather than charging ahead. In a webcast with clients this morning, Leuthold Group’s Jim Paulsen pointed to concrete signs that inflation is already unwinding, obviating the need for higher rates. Indeed, the TIPS market currently predicts inflation will average just 2.4% over the next two years. The Fed’s predicted stagflation may not be correct. Thus, JP Morgan’s David Kelly says the Fed is in “grave danger of being too hawkish.” Even Doubleline’s Jeffrey Gundlach—who complained last year that the Fed wasn’t doing enough to fight inflation—now says they need to slow down or risk recession.

The S&P 500 is down about 20% this year. Both Brown and Gundlach agree that stock and bond markets might have further to fall in the near-term, perhaps 7-10%. But they also caution against selling. We’re much closer to the bottom than the top of this bear market dip, and valuations are getting attractive. And at this point, any good news will spring-load the market higher. Start focusing on long-term buying.