Will the Fed’s Shock Therapy Kill the Bull Market?

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In Barron’s The most recent Big Money poll, survey cited a coming surge in interest rates and high inflation as the biggest risk for equities over the next six months. Curiously, such concerns haven’t dented their confidence. More than twice as many have been net buyers of stocks this year, compared to net sellers. Less than a quarter currently hold a bearish view of equities.

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That approach may be understandable in the face of historically low interest rates. Even though the yield on the 10-year Treasury has risen from 1.34% last November to a recent 2.91%, that’s still well below the average yield of the past 60 years,

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But like a frog that’s been placed in a boiling pot, equities may soon start to sweat from the heat of further increases in interest rates. Advisors can expect increased volatility in the coming weeks and months as the Fed ditches a prior plan to slowly raise interest rates in a steady and measured fashion. Instead, we’re more likely on the cusp of sharper hikes—50 basis points or even 75 basis points—at each of the next few meetings of the Federal Reserve Open Market Committee (FOMC).

Picking up the pace. Fed Chairman Jerome Powell recently conceded that a go-slow approach to interest rate hikes won’t likely help bring inflation down in a reasonable time frame. “It is appropriate in my view to be moving a little more quickly,” he said during an April 21 panel discussion, adding that “there’s something in the idea of ​​front-end loading.” The FOMC will announce the next interest rate move on May 4.

Fed Chair Jerome Powell’s efforts to slow the economy and inflation through a series of sharp rate hikes could cap further back-ups in longer-term yields.

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Photo Illustration by Barron’s Advisor; Getty Images; Dreamstime (2)

Connect the dots, and the benchmark short-term fed funds rate may move up from a current range of 0.25%-0.50% to above 2% by this summer. And by December, we’re now looking at a 74% chance that Fed-set rates will be in the 2.75%-3.25% range, according to the CME’s FedWatch tool,

That range is of great significance to advisors as it handily exceeds the current dividend yield on the S&P 500 of 1.45%. Moreover, BB-rated two-year bonds now yield around 4.3%, which is also a significant amount of yield, according to FactSet.

At some point, perhaps soon, many advisors will start to see that they can get a higher and safer yield for clients from short-term bonds than from dividends. Said another way, equities would need to fall by a substantial amount for the yield on the S&P to rise to a level that provides dividend yields that are commensurate with bond yields.

This doesn’t mean we should brace for a further and sharp exodus from equities. But it does mean that fund flows may start to migrate towards fixed income.

Going long? Meanwhile, the Fed’s efforts to slow the economy and inflation through a series of sharp rate hikes could start to cap further back-ups in longer-term yields. Indeed, as Barrons’ Randall Forsyth has noted, a 3% yield on the 10-year Treasury is a bad omen for stocks. It is perhaps no coincidence that the S&P 500 has slumped more than 250 points (more than 5%) in just the past few trading sessions.

Still, while the 10-year Treasury has made a rapid move towards the 3% mark, it’s not yet clear that such momentum will continue. A lot is riding on near-term economic data points. This coming week, we’ll get fresh reads on durable goods orders, consumer sentiment, and on Friday, a slew of inflation readings.

The Atlanta Fed notes that the economy is already slowing. Its GDPNow forecasting tool implies that the US economy grew just 1.3% in the first quarter, well below forecasts back in early January, when it was assumed that the economy was poised to grow in excess of 3%. If the economy is indeed slowing, then the Fed may not feel compelled to raise interest rates quite as vigorously as many currently expect. In addition, longer-term interest rates may plateau sooner rather than later.

Let’s ponder an alternate outlook. Perhaps inflation will remain at elevated levels in coming quarters, compelling the Fed to raise interest rates for longer than is currently anticipated. They may finish their set of rate hikes at a higher peak rate than is currently being assumed. In such a scenario, a recession might be unavoidable.

For now, let’s assume for a moment that short-term rates will rise by another two percentage points this summer while long rates rise much more modestly in the face of a slowing economy. We can draw several conclusions from this framework. First, many consumer loans such as car loans and credit card debt, which are pegged to short-term rates controlled by the Fed, are poised to keep rising. In response, advisors need to redouble their efforts to convince clients to shed all manner of variable rate debt.

Second, mortgage rates have shot upward to a recent 5.4% (for a 30-year mortgage) and that is quickly separating the wheat (cash buyers) from the chaff (financed buyers) in the home buying market. If mortgage rates rise much further, the current, scorching housing market may cool off faster than expected. ,Barron’s recently surveyed various financial advisors on how they are advising clients with mortgage strategies).

Corporations are now also faced with a rising cost of capital. That’s creating a higher hurdle rate for capital investments, at least those that aren’t financed out of cash flow. That could blunt demand in a range of industries that grow based on capital spending and expansion projects. Another potential headwind for capital goods spending: Inventories might start to look bloated if end demand cools, leading to a “bullwhip effect” that triggers a slump in new orders. Inventories were 12.4% higher in February compared to year-ago levels, according to the Census Bureau.


Credit: www.barrons.com /

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