The Fed Has Already Tightened Significantly

FED TAPERING text on white paper on the light background with charts paper

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The major market averages opened lower yesterday in anticipation of a hawkish tone in the minutes from the Fed’s last meeting, which were released at 2 p.m. Indeed, they confirmed what Fed Governor Lael Brainard said the day before, which is that the central bank plans to tighten swiftly this year with as much as $95 billion per month in balance sheet runoff. The uncertainty of the impact that quantitative tightening (QT) will have on the bond market drove long-term rates (10-year yields) to 2.6% and pressured growth stocks, as investors pivoted to more defensive sectors of the market.

market averages

finviz.com

I think investors need to recognize that the anticipation of aggressive monetary policy has done far more to tighten financial conditions to date than any actions taken by the Fed. The spike in the 10-year Treasury yield to more than 2.6% has resulted in 30-year fixed mortgage rates climbing above 5% for the first time since 2011. Yet all the Fed has done so far is raise rates one time by 25-basis points. Borrowing costs are now meaningfully higher than they were a year ago, which will impact consumer demand as we move forward, but real yields (inflation adjusted) are still negative, which still supports risk asset prices.

10 year yields

The 2-year yield has soared more dramatically this year to nearly the same level as the 10-year and briefly rose above it on two occasions over the past week. The 2-year more closely tracks where investors expect the Fed’s short-term policy rate will be two years from now. When long-term rates fall below shorter-term rates it is an indication that investors are concerned about Fed policy stifling the rate of economic growth to the point of contraction, which is why recession fears are emerging.

2 year yields

stockcharts.com

While an inversion of the 2- and 10-year yields has preceded 7 of the past 8 recessions, such inversions tend to last for at least a month rather than a day, so I am taking the recent warning sign with a grain of salt. A more reliable indicator is the 3-month yield and 10-year yield, which has actually steepened since the beginning of this year. The 3-month yield more closely tracks today’s policy rate, and that is expected to be 50-75 basis points in May when the Fed next meets to raise rates. That is why the 3-month yield is approximately 0.65%. The 3-month yield has risen above the 10-year yield prior to all 8 of the past recessions. We are nowhere close to an inversion of this curve, which is why I am not concerned about a recession anytime soon. Again, this curve is steepening, as seen below, which suggests the current expansion has much further to go.

yield curve

edwardjones.com

Even if we do see both curves invert in the months ahead, investors have had plenty of time to reposition between the time of inversion and when risk assets start to price in a recession. The most recent one to occur in 2019 was on an accelerated time frame because the pandemic hit in February 2020, which was clearly unrelated.

inversion performance

bloomberg.com

We do have the added uncertainty of quantitative tightening combined with a rate hike cycle, but the Fed does have experience with this process from 2017-2019. The difference is that the Fed raised short-term rates four times in advance of starting to reduce the size of its balance sheet by an initial $10 billion per month. That runoff increased gradually up to $50 billion per month one year later. Today, the Fed is discussing a far more rapid runoff on an accelerated cycle of rate hikes. Still, the markets are well aware of the Fed’s intentions and have priced in much of this year’s tightening already. This is why 2- and 10-year yields have risen so dramatically this year. I think it will take a positive real yield on long-term bonds, which means the rate rises above the associated inflation expectation for that time frame, to cause more meaningful damage to stock valuations than we have seen to date. That rate is approximately 3.5% on the 10-year Treasury.

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