Markets Should Not Fight the Fed This Time Around

The markets and the Federal Reserve (Fed) each play a role in a healthy economy. They also feel they know best how to make a good economy a reality. These views differ, especially in dealing with interest rates and what they should look like. In this, their views seem almost opposite. Oh, who are we kidding, they are nearly polar opposites. Of course, it’s important to keep in mind that this economy is different from previous cycles. As a result, we believe it requires a different approach.  

This Time is Different

We have already looked in depth at why this economic cycle is not typical of standard cycles. In fact, this cycle differs from any we have experienced in the last 40 years. After all, never before at least within our lifetimes has America experienced a pandemic and fiscal policies that impacted virtually every household in the United States. Therefore, in our view, this unique situation demands we approach the cycle and the checks and balances that make it work differently as well. Markets seem to believe this is a typical cycle, though, and are acting accordingly. The Fed sees the economy weakening, along with an increase in unemployment. Based on historic moves, we believe the right step for the Fed would be to begin lowering interest rates. However, again, this time is different. Nothing is typical now. The Fed is reading the room differently now, thankfully. However, markets still maintain that it is a typical cycle, hence the disconnect. Check out our Weekly Economics for January 13, 2023, to look at this further to understand what makes this cycle so different. As a result of the experience and knowledge of the Fed and their ability to read the economy accurately, we believe they will maintain high-interest rates for a bit longer.  

The Role of the Federal Reserve in Setting Interest Rates

Before moving further in the explanation of why the markets should not fight the Fed this time around, it’s important to understand the role of the Federal Reserve when it comes to setting interest rates in particular. While the Fed manages the money supply and regulates financial markets, it also sets interest rates. In some cases, such as during the 2008 meltdown, and the COVID-19 crisis, it also served as a lender. 

 It is no surprise that with the power held by the Fed that it is often subject to controversy, namely from various experts not agreeing with its decisions or movements. When it comes to the Fed’s historic role, it was primarily to maintain stable prices and then secondly to help achieve full employment. Stable prices are often considered to keep the annual inflation rate at a target of 2 percent. Of course, with the uniqueness of these past few years, that has shifted slightly. Now, the Fed is allowing higher inflation. 

 How High is Too High, When Will it End?

Now, back to the subject at hand, how high is too high in terms of interest rates, and who is right, the market or the Fed? That has been the question to answer for the past year. However, what many don’t understand is the answer doesn’t necessarily lie with the Fed. Instead, the markets hold this power, though they might not recognize this fact. What it basically comes down to— in the most simple terms— is that the more the market pushes for long-term interest rates to come down, in our opinion the more the Fed will tighten up its policy. 

Wait a minute, didn’t we just say that the Fed sets the rate and determines how high-interest rates will go? Well, yes and no. The Fed only has control over one rate of interest, the federal funds rate. The other interest rates are based on market forces. Yes, the Fed can try to guide the markets, meaning pushing them towards what they feel they need to see. However, markets are many times stubborn. They don’t want to listen to what the Fed is trying to say. This is one of those times.   

The Mortgage Rate Treasury Yield

The Fed is most likely disappointed with the fact that the 10-year Treasury yield came down, and then mortgage rates followed over the last couple of months. (10-Year Treasury Yield: This rate is the yield investors receive when investing in treasury security {US government issued} with maturity duration of 10 years. 

This decline in mortgage rates has improved some housing market measurements like new home sales. The existing home sales have declined and have since moderated considerably throughout the same time. While this sounds good, this is not exactly what the Fed wanted to see. The Fed utilizes the housing market to conduct monetary policy. The result of this is home prices that look too “frothy” as described by former Fed Chairman Alan Greenspan. To further explain the term frothy, this is a common economic term that implies that asset prices are detached from an actual value. In other words, a frothy housing market presents unsustainable price appreciation. 

Why Would Housing Market Stabilization be Negative?

In addition to the problems outlined above, the stabilization of the housing market can have other negative effects. This can play directly into the ability of the Fed to bring down inflation to its target 2% shelter costs. If financial conditions continue to improve and home prices stabilize, this could mean that shelter costs will not weaken enough to help bring down inflation. 

Killing a Fiscal Cycle Via Monetary Policy, How is That Going?

Again, we have looked several times at how what the U.S. economy faced these last several years differed from a typical monetary cycle. In reality, as we explained it was not a real monetary cycle at all. Yes, the money supply increased, at nearly exorbitant amounts, at least compared with typical economic standards. However, as we explained, it wasn’t the banking system that was creating this money through the lending process, which would be part of a regular monetary cycle. Instead, it was an increase in money supply due to unprecedented fiscal policy during the COVID-19 Pandemic. In other words, it was transferred from the federal government to the pocketbooks of Americans.  

What This All Means For Monetary Policy

To put it simply, we believe this is the reason that the Fed is having trouble using traditional methods to tighten the monetary policy through their typical actions of increasing federal funds rates. Due to the inflow of funds from the government to Americans, many middle and higher-income Americans have continued to have access to funds, keeping the service side of the economy going. In addition, since labor markets have remained strong and inflation is working its way down, this increases real disposable income, which has declined over the past few years. This has created a recovery of sorts. Admittedly, though, many lower-income Americans are not experiencing this and have run out of excess savings. Their experience is different from that of the middle and higher income levels.  

Don’t Fight the Fed! 

If the market continues to fight the Fed and push yields on the 10-year Treasury down, the Fed will only continue to increase interest rates in an attempt to cool down the economy. In our opinion, the end result of these actions would present a risk of sending the U.S. economy into a deeper recession than what we have predicted. While fighting to correct and keep the market strong is normally advisable or at least understandable, this current state of the economy, based on previously unheard-of circumstances demands a different approach. Therefore, our message to the markets is this: don’t fight the Fed, at least not this time around!

Any opinions are those of Brockmeier Financial Services, LLC, and not necessarily those of RJFS or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of the strategy selected.