With markets stalling as we enter the 4th quarter, it seems timely to discuss what’s moving markets. Three specific items are worth discussing as we enter the last part of 2023: Interest rates, Economic Growth, and Free Markets.
Interest Rates
To start this discussion, let’s focus on this boring chart of the 10-year US Treasury yields going back to 1962.
There are three main observations to take from this data:
- The current rate on the 10-Year US Treasury bonds is 4.98% (as of October 19, 2023). This is the highest rate since July 2007.
- The average 10-year treasury rate (from 1962 –2023) is 4.25%, or ~0.75% below the current rate.
- Financial markets have not seen rate increases of this magnitude in over 40 years, meaning that most market participants were not participating in the market when this last occurred.
I’d like to spend some time on that last observation, because it is key to understanding the volatility and concerns that the current rate environment is causing for both markets and investors alike. For some reason, likely the past 40 years of steadily decreasing rates, there is this strong, borderline evangelical belief, that “rates will drop soon.” This is evident in social media circles where realtors are recommending buying houses with statements like “Marry and house and date the rate, you can always refinance later.” While this was perfectly logical, and profitable, from ~1982 – 2020, there is no guarantee that rates will go up or down anytime soon and anyone who claims to know the direction (and potential magnitude) of rates changes is at worst a liar and at best a charlatan.
Instead, we should focus on the reality of how interest rates, particularly how long-term interest rates move:
- Inflation Expectations: When inflation is anticipated to run higher for longer, long-term interest rates increase, as investors demand a premium for locking in yields. The opposite happens when inflation is trending down, as that should move interest rates lower.
- Economic Growth: When economic growth is strong, so too are the returns for investing in risky assets, which in turn means investors will demand higher returns for safer assets to attract capital. The opposite happens when economic growth slows, as returns for risky assets decrease and the demand for safer assets increases, reducing rates.
Those two variable combine to makeup the traditional economic definition of what moves long-term rates. Notice that one very important talking point, and influence on rates, isn’t listed above – The Federal Reserve. The Feds gets its own section that is (as a warning) fairly wordy.
The Fed
Let’s talk about The Fed. Most of the coverage in financial media is targeted at the Fed Funds Rate, which is the short-term rate The Fed pays on overnight deposits. This rate is currently 5.25% – 5.50%. While this does deserve significant attention, what has become evident over the past 12 months (and arguably the past ~15 years) is that their balance sheet management is an equally and potentially more powerful tool for managing interest rates.
The Fed has the ability to buy bonds (including mortgage-backed bonds) across the yield curve for a variety of reasons. The more bonds they buy, the larger their balance sheet gets, while sales of securities decrease the balance sheet’s size. The rationale for having this power is simple: be the buyer of last resort when the economy needs one. This is the whole reason for monetary policy in the first place – to stabilize markets in times of panic.
Since the start of the COVID pandemic in 2020, The Fed has bought bonds… and bought a lot of them, more than doubling their total assets from March 2020– March 2022.
This 2-year period (March 2020 – March 2022) when The Fed doubled its balance sheet also coincides with record low mortgage rates. Why? Because The Fed was buying mortgage-backed bonds (and other securities) like crazy! Note the percent change in The Fed’s balance sheet (red) vs. the change in mortgage rates (blue). If anything, this doesn’t suggest that rates will go down soon, but rather highlights just how responsible The Fed was for the record low rates observed post-pandemic.
Flash forward to today, and The Fed is not buying bonds of any type (and thus the balance sheet growth is negative as illustrated by the red line being below zero on the pervious chart). While not the sole cause long-term rate increases, it is very hard to argue that this isn’t a significant contributor. So the question becomes “When might The Fed stop reducing the size of their balance sheet, or even start buying bonds again?” knowing that the likely impact on markets would be lower rates.
Let’s go back to the original purpose of The Fed: To be the buyer of last resort during times of panic. Does the economy look to be in panic mode?
Economic Growth
Let’s look at the last three quarters of economic growth (per the Bureau of Economic Analysis):
- Q1 2023: 2.2%
- Q2 2023: 2.1%
- Q3 2023: 5.4% (Estimate as of October 18, 2023 per atlantafed.org)
In spite of the increasing rates, economic activity has remained strong. Barring an economic crisis, it is hard to imagine The Fed needing to step in and increase its balance sheet size, or, at minimum, change its current policy of gradually shrinking its balance sheet. This is especially true considering inflation remains above target, as Fed buying can be seen as stimulating an economy that is already strong. I’d much rather have a healthy economy and a Fed that is reducing its footprint on financial markets than a recession – or worse – which induces an increase in Federal Reserve open market interventions.
Free Markets
Maybe what investors, and markets in general, are having trouble digesting is a return to a classical view of free markets, one where The Fed doesn’t rush in to stabilize markets at the first sign of trouble. One where Capital Hill politicians don’t rush to spend trillions of dollars without second thought because rates will remain “low forever.” Maybe, just maybe, we are experiencing, in a limited fashion, equity and bond market volatility without significant intervention from policy makers. While this adjustment maybe uncomfortable, it should be viewed as beneficial in the long-term. I mean, let’s be honest here, 30-year mortgages should never have been below 3%, digital rocks should have never been worth $1.3 million, and the stock markets shouldn’t go up steadily every year. Investing should come with some degree of risk, as that is the only way to earn a decent return. Times of transition can be difficult, but are necessary, and will certainly reward long-term investors.
In closing, the chart below illustrates the S&P 500 total returns (blue) and largest maximum decline (black) for each calendar year from 1980-2022. On average, the market declined by 14.2% at some point during the calendar year, yet still earned a positive return of 12.4% over this period. The current downturn is ~7.9% (from 7/31/2023 – 10/20/2023). Painful without question, but a normal part of participating (and earning) positive investment returns.
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