Tom Wald, CFA®, Chief Investment Officer, Transamerica Asset Management, Inc.
In this article we review:
Market reactions to the Federal Reserve September meeting
Changes to the Fed dot plot and expectations of future interest rate levels
Post-meeting commentary by Chair Jay Powell regarding inflation and future policy
The current slope of the Treasury bond yield curve and how it might change in the year ahead
How upcoming economic data and events could impact Fed Policy and the path of interest rates
Our outlook on the fixed income and equity markets
The Federal Reserve took no action at its September meeting but nonetheless roiled markets regarding their expected path of future interest rates. In the aftermath of this meeting and corresponding market reactions to it, we believe the following points are important to investors:
Markets immediately focused on dot plot revisions. While maintaining the fed funds rate at a target range of 5.25–5.50%, it was a change in the “participants assessment of appropriate monetary policy” (aka “Fed dot plot”) that created the bulk of ensuing market volatility. In this anonymous survey of the Fed’s 19 voting members, median expectations of future fed funds rates included one more quarter-point rate hike to a lower bound of 5.50% in CY 2023 but, more importantly, expectations of a 5.00% lower bound at year-end 2024 and 3.75% at year-end 2025. These were higher than the previous June dot plot expectations for these dates of 4.50% and 3.25%, respectively. In our view, this change was the predominant culprit resulting in a rise of the 10-year Treasury bond yield to 4.55% (September 26), its highest level since 2007, as well as a decline of about 2% in the S&P 500® to its lowest point since the end of May.
Post-meeting comments also contributed to market volatility. We would categorize the commentary by Fed Chair Jay Powell following the meeting as modestly hawkish, though stock and bond markets reacted harshly to his verbiage. While he did reiterate past data dependent language such as “we will proceed carefully as we assess incoming data and evolving outlooks and risks,” there appeared to be a good bit of focus on other previously used phraseology addressing a potential additional rate hike by year-end, including being “prepared to raise rates further” and “the process of getting inflation sustainably down to 2% has a long way to go.” When combined with the dot plot changes, this language appeared to be interpreted by the markets as a good bit more hawkish than after the previous June and July meetings.
We caution not to read too much into Fed dot plots. It is important to recognize that Fed dot plots simply reflect expectations at a given point in time and that actual future policy decisions will be driven by upcoming economic data and events. In addition, history has shown Fed projections of future rates to be less than highly correlated with actual outcomes. At this point, it is our expectation, given declining rates of inflation and a likely economic slowdown in the months ahead, that the lower bound fed funds rate by year-end 2024 is likely to turn out to be lower than the dot plot median of 5.00%.
That said, the change in the Fed’s perspective did force markets to finally accept the likelihood of a “higher-for-longer” interest rate environment and ultimate “dis-inversion” of the yield curve in the year ahead. Since March 2022, when the Fed began this current tightening cycle, the markets have repeatedly and incorrectly anticipated a pivot to rate cuts at various times. However, it now finally seems apparent after this most recent September meeting that the notion of rate cuts before 2H 2024 has, for the most part, been put to rest. Hence, playing a major role in the upshot in longer-term yields.
Future yield curve steepening now being recognized by the markets. As investors know, inverted yield curves are market anomalies historically lasting on average not much longer than a year’s time. The current 3-month to 10-year inverted slope has been in effect since October 2022. Historically, yield curves have followed a pattern of inverting prior to recessions and steepening back into an upward slope during recessions. There are, of course, three ways a yield curve can transform from inverted to upward sloping: 1) short-term rates fall 2) long-term rates rise 3) some combination of the two. Therefore, the recent rise in long-term rates likely reflects the market’s new reality check that the third scenario is a likely outcome between now and the end of 2024.
Economic data could weaken considerably, thereby impacting the prospect of future rate hikes. Despite what looks to have been strong 3Q gross domestic product growth, the economy could slow and potentially fall into contraction during 4Q and into CY 2024. This could be driven by lagging impacts of the Fed’s previous rate hikes, downward trends of leading economic indicators, depleting consumer savings, rising credit card debt, and the resumption of student loan payment requirements. We also see core rates of inflation as likely continuing to mitigate into the 3% range moving into CY 2024. All considered, these developments could dissuade the Fed from raising rates further and potentially result in more than two rate cuts in the latter half of 2024.
While still a close call, we expect the Fed not to raise rates between now and year-end. Given what we expect to be weakening economic data, a rising probability of a mild-to-moderate recession and mitigating rates of inflation in the months ahead, we see a slightly better than even probability the Fed holds tight at its current target range of 5.25–5.50% on the fed funds rate. We’ve also upwardly revised our year-end target on the 10-year Treasury yield to approximately 4.20%, still below current levels, as a more challenging economic environment emerges and prospects of rate cuts in 2H 2024 become more evident.
Corporate bond yields look advantageous. Given recently elevated yields (ICE BofA Corporate Index effective yield 6.00% and ICE BofA High Yield Index effective yield 8.72% – September 25), we view investment-grade and high-yield corporate bonds as opportunistic for investors. Given the widely anticipated nature of a pending downturn and overall balance sheet management of corporations since the pandemic, we believe credit risk is more benign than prior to most other previous recessions.
We are maintaining our year-end 2023 price target on the S&P 500® of 4,600 and believe there is further upside to potentially record highs for stocks during CY 2024. Tail wind catalysts for equities include declining inflation, the conclusion of the Fed’s current tightening cycle, and the ability of corporations to effectively navigate growing earnings through a mild-to-modest downturn. We also believe such conditions favor growth stocks over value.
Clearly more drama and market volatility await the fixed income and equity markets as the Fed finishes its current tightening cycle and determines what it believes to be an appropriate period to maintain short-term rates at current or slightly higher levels. During this time ahead, investors may want to consider investment-grade and high-yield bonds balanced with a growth-oriented stock portfolio.
Investments are subject to market risk, including the loss of principal. Asset classes or investment strategies described may not be suitable for all investors.
Past performance does not guarantee future results. Indexes are unmanaged and an investor cannot invest directly in an index.
Equities are subject to market risk meaning that stock prices in general may decline over short or extended periods of time.
Fixed income investing is subject to credit rate risk, interest rate risk, and inflation risk. Credit risk is the risk that the issuer of a bond won’t meet their payments. Inflation risk is the risk that inflation could outpace a bond’s interest income. Interest rate risk is the risk that fluctuations in interest rates will affect the price of a bond. Investing in floating rate loans may be subject to greater volatility and increased risks.
Growth stocks typically are particularly sensitive to market movements and may involve larger price swings because their market prices tend to reflect future expectations. Growth stocks as a group may be out of favor and underperform the overall equity market for a long period of time, for example, while the market favors “value” stocks. Value investing carries the risk that the market will not recognize a security’s intrinsic value for a long time or that an undervalued stock is actually appropriately priced.
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The 10-Year U.S. Treasury bond is a U.S. Treasury debt obligation that has a maturity of 10 years.
S&P 500® Index: An unmanaged index of 500 common stocks primarily traded on the New York Stock Exchange, weighted by market capitalization.
The ICE BofA U.S. High Yield Index tracks the performance of U.S. dollar denominated below investment grade rated corporate debt publicly issued in the U.S. domestic market.
ICE BofA U.S. Corporate Index — This index tracks the performance of U.S. dollar-denominated, investment-grade corporate debt publicly issued in the U.S. domestic market.
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