CapitalTime
Articles on investing and capital management, with a quantitative focus.
Listen to the Federal Reserve
2023-01-11
These comments are about the US Federal Reserve (or “Fed”) and their policy interest rate. The Bank of Canada usually follows the Fed policy quite closely.
I think it’s important to listen to the message coming from the Federal Reserve. Several presidents of regional Federal Reserve banks have been giving media interviews over the last few months. Jerome Powell, the Chair of the Federal Reserve, also speaks to the media quite frequently.
Here’s what I am hearing them say:
Inflation is very high, and far above the Fed’s target rate. They will tighten financial conditions until they are confident that inflation is back down to the 2% target rate. The Fed policy interest rate is likely going higher, and they will hold interest rates at the higher level until they are certain that inflation is extinguished. Some heads of regional Federal Reserve banks want the Fed funds rate above 5%.
The bond market disagrees
The bond market does not seem to believe that the Fed will do this. The 2 year treasury bond yield has been steadily decreasing for the last two months and currently sits at just 4.2%.
The bond market doesn’t think that the Fed will actually get above 5%, and certainly doesn’t think that they will hold rates above 5%. Instead, the market thinks that the Fed will start cutting interest rates soon.
Why this matters
The Fed is saying they are still on a “tightening” path, whereas the market thinks the Fed will very soon be on a “loosening” path.
Those are very different, and there are implications for stocks, bonds, real estate, and businesses. For example, the Fed is saying that corporate financing conditions will tighten (rates will go higher) this year, and possibly next year too. In contrast, the stock and bond markets are pricing looser financing conditions (rates will go lower).
I can’t predict the future, and the market may be right. However, I think it’s a good idea to consider the possibility that the Fed actually does what they say they might do:
- they could raise the Fed rate to 5% or higher this year
- they could hold the policy rate high for some time
- inflation may not drop all the way to 2% for years
- the Fed may not cut rates for years
Obviously, one should not attempt to time the market or adjust their portfolio based on predictions about the future. Nobody has any idea what will actually happen in the years ahead.
However, I think it’s important to consider these possible scenarios. I have recently been asking myself if my investment portfolio, and business plans, can tolerate the conditions described by the Fed.
— Jem Berkes