At the beginning of 2022 a bullish outlook on corporate profits created expectations for a higher market, though not likely a better performance than the previous two years. But during the first quarter, the narrative changed. The Federal Reserve (Fed) was forced to abandon its outlook that inflation was “transitory.” That and the Russian invasion of Ukraine combined with lingering supply chain interruptions to increase inflationary pressures. What started as a “low and slow” path of Fed interest rate hikes quickly morphed into a much more aggressive Fed stance. A series of hikes and a reduction in the Fed balance sheet brought on a high level of market uncertainty and the coinciding decline in asset values.
In the face of interest rate increases, the U.S. economy remained resilient—perhaps too resilient for the Fed’s liking. The Fed continued its hawkish stance and language into the second half of 2022, signaling an ongoing restrictive policy and leaving the financial markets with little confidence in a quick Fed pivot to lower interest rates.
As we head into 2023 there are signs of inflation pressures easing, and expectations are rising that as inflation eases the Fed will slow its rate increases, halting or even lowering rates in the second half of 2023. The Fed itself has not indicated a reverse of its course and has in fact continued to talk tough on inflation, even as Consumer Price Index numbers ease, creating a gap between those market expectations and Fed policy.
The Fed has consistently projected that the Fed Funds Rate will peak between 5 and 5.25 percent, an increase from the current (as of this writing) 4.25 to 4.5 percent. But the investment markets are pricing in a more modest increase, of just .25 percent, and a lowering of rates by November 2023. This expectation gap will cause short-term volatility as the economic data continue to roll in and are interpreted and the Fed comments on the data.
Based on recent trading, the financial markets are telling the Fed that it is time to take a less aggressive stance, though the Fed has yet to signal it is in agreement. When will the other shoe drop? Investors will continue to speculate whether the Fed can engineer a soft landing—an economic slowdown with lower inflation and no recession—or if the rate increases will cause a hard landing, including a decline in corporate earnings and a more substantial, broader economic slowdown or recession.
There is a direct relationship between lower interest rates and higher financial asset prices. As such, the Fed is very much in control of current asset prices. The evidence is in how the financial markets swing wildly on Fed Chairman Jerome Powell’s comments.
Looking long term, given corporate profits remain strong and the U.S. avoids a deep recession, it is not a matter of if the Fed pivots, but when. The longer the Fed persists, the longer we will have to wait for a sustained market rally; the sooner the Fed pivots, becomes more dovish on inflation, the greater the likelihood for a substantial market rally.
Timing a Fed pivot is all but impossible; the Fed could change its policy at any moment. Maintaining your investment plan should be your first and most steadfast policy in 2023. There will be a new bull market. The first leg up will be substantial and you don’t want to miss it sitting on the sidelines. Investor patience will be rewarded.
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