The September swoon continued last week, as stocks sold off hard after the Fed’s decision to leave interest rates unchanged. This type of seasonal weakness shouldn’t be a surprise. We’ve been discussing the potential for August and September volatility for a while now. It’s important to remember the S&P 500 had its best start after seven months to any year since 1997, so some type of weakness in the troublesome months of August and September is normal. Pre-election years tend to be very strong for stocks the first half of the year; then they chop around in the fall months before a furious late-year rally to new highs. This year has checked the first two steps off the list, and we still expect new highs before it ends.
- Stock weakness continued, but this wasn’t unexpected.
- A government shutdown looms, yet history suggests this is a non-event for investors.
- The Federal Reserve paused rate hikes at its September meeting.
- The Fed made a big shift in its projections and is now much more bullish on the economy.
- Expectations for a stronger economy also mean the Fed is projecting fewer rate cuts next year.
September hasn’t been fun for investors, but let’s put it in perspective. The S&P 500 is a good month away from being back on track to setting new highs and stocks are still up close to 15% for the year. For bullish investors, it can be helpful for stocks to pull back and catch their breath before what we expect will be a strong fourth-quarter rally.
What About a Government Shutdown?
Many people are concerned about a potential government shutdown. Odds are we are headed for one, but the good news is it’s unlikely to mean much for investors. The last shutdown lasted for a record 35 days, yet stocks added more than 10% over that period. Once the shutdown was over, they added another 24% the following year. Historically, shutdowns are short-lived, so markets don’t have much time to start reacting before they are over. It’s difficult to believe this time will be different. With an election coming soon, do politicians really want veterans not getting their benefits? A shutdown may be coming, but we don’t believe it will last long.
The Fed Pauses but Gets Bullish on the Economy
The Federal Reserve chose to pause on interest rate hikes at its September meeting, leaving the federal funds rates unchanged at 5.25-5.50%. This was not unexpected, but the members did give us a lot of new information. They updated their economic projections, which captures their views on what the economy, employment, and inflation will do under appropriate monetary policy.
Here are five takeaways.
One: Signs point to no more rate hikes.
The Fed kept its terminal rate expectation unchanged at 5.6%, which implies Fed members expect one more rate hike before the end of the year. However, Fed Chair Jerome Powell was extremely cautious about the path forward. He said the Fed has already done a lot and very fast, and as it gets closer to what Fed members think is the appropriate policy rate, the risk of over-tightening increases. Since they moved so aggressively already, Powell said the Fed can afford to pause and wait to see the full impact of everything it has done. That doesn’t sound like someone who wants to raise rates further. Instead, penciling in one more rate hike simply gives the Fed optionality, in case inflation surprises higher once again. Right now, that seems unlikely.
Two: Fed members are buying that the economy is strong.
The Fed increased its real GDP growth projection for 2023 from 1% to 2.1%. That is a huge shift and an acknowledgement that the economy is strong. The expectation for GDP growth in 2024 was also increased from 1.1% to 1.5%. Powell said one reason for robust growth is household and business balance sheets are much stronger, and so spending has held up. He also speculated that policy rates may not have been restrictive for long enough for their full impact to be felt.
Three: A stronger economy raises the bar for rate cuts.
The Fed had projected some rate cuts in 2024, but expectations for a stronger economy has caused those projections to fall. In June, the Fed projected the 2024 rate at 4.6%, implying 1% worth of cuts. The Fed is now expecting just 0.50% in cuts, taking the 2024 rate to 5.1%.
A stronger economy has resulted in the Fed moving its rate expectations quite a bit higher over the course of the year. Since last December, the Fed has moved the 2023 rate up from 5.1% to 5.6% and the 2024 rate up from 4.1% to 5.1%
Four: The Fed now expects a soft landing.
Powell was very reluctant to admit this, but the Fed’s projections explicitly laid it out. Fed members lowered core inflation projections for 2023 from 3.9% to 3.7%, and they now expect inflation to fall to 2.6% by 2024. At the same time, they lowered their unemployment rate projection for 2023 from 4.1% to 3.8%. They still expect the unemployment rate to rise to 4.1% by the end of 2024. But that’s not a lot, and it’s a big shift down from the 4.5% they estimated in June.
In short, the Fed is no longer expecting recession-like conditions that would cause the unemployment rate to jump significantly.
Powell explained that a strong economy by itself is not a problem, as long as it doesn’t cause higher inflation. In short, we could have a strong economy, low unemployment, and falling inflation, which is what they now expect.
Irrespective of whether the above scenario happens (note: we believe it can and have been predicting as much since last year), the fact that the Fed buys into this is huge and a fairly dovish sign. If inflation continues to fall, and we believe it will, a strong economy and low unemployment alone shouldn’t push the Fed to keep policy tight.
Five: The Fed didn’t change its long-run rate expectation.
Fed members left their expectation for long-term policy rates at 2.5%, which is where it’s been over the past decade. So, they believe the same structural forces that have kept economic growth relatively slow (around 2%) are still in play.
This is different from what investors expect. Market expectations for the implied policy rate in 2027 has increased from 3% to almost 4% over the last four months. This has resulted in a significant increase in long-term Treasury yields. Ten-year nominal yields are close to 4.50%, which is the highest they’ve been since 2007. Even yields on 10-year Treasury Inflation-Protected Securities, i.e., real yields, have hit 2%.
Higher long-term yields, especially real yields, are a sign that investors expect stronger growth further out into the future. Powell acknowledged that when he was asked why long-term yields were rising. He said it is not about inflation expectations but has more to do with economic growth expectations.
The disconnect between the Fed’s and market’s expectations will eventually have to be reconciled. Either the Fed moves higher or market expectations fall. If it’s the former, we can expect long-term borrowing rates, such as mortgage rates, to stay relatively higher for much longer. If markets shift expectations down, long-term borrowing costs will fall. In other words, there’s a lot riding on this.