The Fed May Be Forced To Stop Before It Hits 4 Rate Hikes This Year
The Fed's aggressive tightening plans heading into a slowing growth environment won't end well.
If there’s one key takeaway from Jerome Powell’s press conference last week, it’s that the Fed is going to do whatever it takes to combat inflation. This is a sharp reversal from the Fed of the past several years whose goal seemed to be inflating risk asset prices as far as it could as long as inflationary risks didn’t rise along the way. It pretty much succeeded in this unwritten mandate up until about a year ago. Powell even tried to force the word “transitory” upon the markets as a means of justifying ultra-loose monetary conditions despite evidence building that suggested inflation wasn’t going to be transitory at all.
Now, the Fed is stuck. Economic growth is now slowing instead of expanding, but inflation is up to 7% so the Fed almost has no choice but to raise rates into a contracting growth cycle. This is the pickle the central bank has gotten itself into - it’s going to have to choose between economic growth and inflation control, but likely not both. Powell’s statement that the economy can likely survive several rate cuts without materially harming the strength in the labor market suggests that the Fed is going to hit the gas at the March meeting and may not stop until well into 2023, depending on how things are going later this year.
And that’s where I’m beginning to get more skeptical that the Fed is going to be able raise rates 4 times this year. Unless Powell takes a “control inflation at all costs” mentality and doesn’t worry about the potential collateral damage, I think it’s becoming more likely that the Fed is going to need to stop at around 2 rate hikes. I think there’s an increasing likelihood that this all ends with another recession in 2023 and the Fed is back to dovish instead of hawkish.
The markets, I believe, are coming to that consensus as well. The 10Y/2Y Treasury yield spread has plunged all the way to 0.60%. That’s down 100 basis points from its March 2021 peak and the lowest it’s been since October 2020. Investors continue to push rates higher on short-term debt in line with expectations of what the Fed is going to do, while pushing rates down on the long end based on expectations of what the economy is going to do. We’re not yet near the 0% mark, which would traditionally signal that a recession is coming, but it may not be long until we get there. High P/E stocks are getting repriced lower in light of higher rates. Even credit spreads are starting to creep higher again. The spread on BBB-rated debt is up to 1.33%. That’s up 16 basis points in less than a month and the highest it’s been at since late 2020 as well.
I wouldn’t necessarily shift away from the consensus forecast of 4 rate hikes in 2022 just yet. Last week, Powell took a pretty hardline stance on inflation control. As recently as December, on the other hand, he emphasized flexibility on policy decisions so as not to make another mistake like he did in 2018. Which stance Powell ultimately ends up taking will likely determine where the financial markets are headed for the remainder of the year.
Here’s a scenario I can see playing out in 2022.
The Fed maintains its hawkish stance and effectively indicates it’ll raise rates a quarter point at each quarterly meeting this year. The addition of balance sheet runoff in the background is a little too hawkish for investors and equities don’t like it. Volatility remains elevated and the major averages decline another 10% from here. Year-over-year inflation rates begin declining quickly as high base effects wear off and supply chains slowly loosen. GDP growth rates are disappointing (the 4% growth from inventories suggests the Q4 number isn’t as strong as it appears) and begin moving towards the 0-2% range. The yield curve inverts. Powell realizes that he won’t be able to land this thing gently and decides that he simply can’t continue raising interest rates into what’s looking more and more like a new recession. He hits the brakes on rate cuts and quantitative tightening at some point in the 2nd half of 2022.
That’s the point where equity markets reverse - at Powell’s hawkish-to-dovish pivot. Stocks start moving higher again, led by growth, tech and mega-caps, and it begins looking like 2020 all over again. The Fed has knee-capped itself once again and proven to the world that it’s simply unable to normalize financial conditions because it can’t get out of its own way and doesn’t really know what it’s doing.
There’s a chance that perhaps Powell surprises me and is able to engineer a soft landing that balances growth and inflation control, but the scenario I laid out above is starting to become my base case scenario for 2022.
With that being said, let’s look at the markets and some ETFs.
Energy continues to be the only sector generating positive gains in January. The 18% gain of the Energy Select Sector SPDR ETF (XLE) easily outdistances the rest of the market, but years of underperformance mean that it accounts for a relatively tiny 3% of the total U.S. equity market. Those whose portfolios are heavily exposed to tech stocks, S&P 500 index funds or even total market funds probably have almost no exposure to these huge gains.
Nothing else is demonstrating any strength at the moment. The consumer staples sector, which has significantly outperformed the S&P 500 since November, is perhaps the 2nd best looking group at the moment and utilities looks a little better relatively speaking, but this is a weak environment almost across the board. Growth sectors, which are being punished by their high valuations, have performed the worst in the intermediate-term, but it’s industrials and materials stocks that are demonstrated the worst short-term relative strength.
I laid out my case above for why I believe that there is more short-term pain ahead, which probably means small-caps and cyclicals could be in particular trouble. If I were forced to pick, I’d continue favoring defensive sectors here, but if growth is indeed slowing quickly and Treasury spreads continue to narrow, I’m not sure there will be many safe places to be.
Tech, communication services and consumer discretionary stocks are very weak across the board with double digit losses over the past month common among most subsectors. Blockchain and robotics stocks have pushed well into oversold territory and could be setting up for a little mean reversion bounce. Leisure and recreation stocks are holding up comparatively better being tied to what many anticipate will be a release of bottled-up demand once omicron begins to subside later this year. Homebuilders, which were among the best performing groups of 2021, have turned the corner and become one of the worst performing market groups of 2022.
The growth-to-value rotation we’ve seen in the equity markets is resulting in a similar investor flow rotation out of growth and into defensives and cyclicals. Over the past month, defensives/cyclicals combined for a net $17 billion in inflows. The three growth sectors have seen nearly $8 billion in outflows. On a relative basis, consumer discretionary is seeing the biggest exodus, but tech sector ETFs are seeing some significant outflows for the first time in months.
The $2 billion of inflows into consumer staples is representative of the move we’re seeing into defensive sectors.
The energy sector is still the undisputed king of this market. In my weekly market group report that I generate, the 6 segments of the market with the highest relative strength at the moment all come from the energy sectors - MLPs, oil services, oil explorers, natural gas, midstreams and natural resources. Strong demand, higher energy prices and the occasional political disruption are all supporting higher crude oil and gasoline prices. The clean energy sector, including solar, hydrogen and wind, is in extremely oversold conditions, but has thus far failed to generate any momentum that would pull it out of its slump.
Financials are still looking OK here, but the stabilization of interest rates on the long end of the Treasury yield curve has put a short-term cap on performance. Banks had been among the leading performers within the sector, but strength has balanced out to include other segments, such as capital markets and insurance stocks. High risk BDCs have been relatively flat year-to-date and have managed to avoid a lot of the market damage.
Industrials and materials are following more of the broader cyclical trend that has investors fearing a significant slowdown in growth later this year.
Defensive sectors are outperforming on a relative basis, but still looking weak on an absolute one. Utilities are still managing to outperform the S&P 500 as they have since November. Healthcare remains somewhat volatile and disconnected from what utilities and consumer staples have been doing. Real estate is weakening as the rise in interest rates make high yield REITs look less attractive and acts as a headwind to mortgage activity and the housing market.
Crude oil, natural gas and the dollar remain very strong. The greenback, in particular, has been picking up steam again as the Fed hits the gas on its policy plans. The story is the same with precious metals. Gold is still flat despite high inflation concerns. Industrial metals are weakening, while lumber prices come crashing back down to earth.
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