By Daniel McGarvey, Portfolio Analyst
In his speech at Jackson Hole in late August, Federal Reserve Chair Jerome Powell firmly stated that the Fed has an unconditional responsibility to deliver price stability, even if that results in some pain for the economy. Markets immediately reacted to this hawkish tilt and reduced the odds of rate cuts in 2023, but it’s possible that the Fed will need to continue to tighten even more than markets expect.
There is evidence that economic momentum is weakening and inflation could be peaking, but the labor market is still tight, and elevated inflation could remain sticky. In the 1980s, it took three years and two recessions to get inflation under control, so it would not be too shocking if our current situation also turns out to be more of a drawn-out process. Furthermore, Fed tightening typically stops after the federal funds rate surpasses the consumer price index (CPI), indicating that talks of the Fed pivoting are likely premature (see chart below, as of August 31). That being said, the current odds are that it will at least stop raising rates early next year.
Chart provided by Strategas Research Partners LLC.
Another consideration that gets less media attention is that the Federal Reserve has now ramped up the unwinding of its balance sheet by allowing its bonds to mature. This measure, called quantitative tightening, should also have the effect of raising bond yields and suppressing business activity. What is uncertain is how meaningful that impact will be and whether it will help reduce inflation because quantitative tightening tends not to be as symmetrically impactful as quantitative easing.
Despite all these monetary tightening concerns, one encouraging sign is that markets tend to outperform in the 12 months after midterm elections, with an average return of 16.3%.
In August, the S&P 500 reversed course from its summer run to end the month down -4.1% and -16.1% year-to-date. The 10 Year Treasury rate rose from 2.64% to 3.13% over the month as the yield curve remained inverted. The Bloomberg US Aggregate Index fell -2.8%, and high yield spreads tightened and then rose again to finish at 4.9%. Oil prices are still relatively high but continued to retreat in August, with WTI crude oil falling from around $95/barrel to $88.
Charts provided by YCharts, Inc.
Daniel is a Portfolio Analyst at Stonebridge Financial Group and works on portfolio analysis and other related tasks. When away from the office, Daniel spends his time playing guitar, reading, and exploring the outdoors.