By: Russ Kamp, Managing Director, Ryan ALM, Inc.
Four decades of falling rates and easy (supportive) monetary policy certainly have combined to create an expectation among US investors that US interest rates will be low forever and that the Fed will step in at the first sign of weakness. This assumption has led investors to the idea that a great pivot will soon occur or that at the very least, the Fed will engineer a “soft” landing in which employment isn’t harmed, wages fall back to <2% annual growth, inflation quickly evaporates, and stocks can once again resume their upward trajectory. In fact, they so believe this theory that they have driven long-term US interest rates down to levels not seen in months. In the process, they have created a more challenging environment for the Fed to actually accomplish its principal objective of thwarting inflation.
Despite the Fed’s aggressive action during the past 10 months, financial conditions appear to be “normal” as depicted in the chart above. Where is the tightness? For all the handwringing regarding the massive upswing in rates, it certainly doesn’t appear to me that the Fed has actually accomplished much of anything, yet! Sure, inflation, as measured by the CPI, and fallen from the current peak of 9.1% to 7.1%, but that is still 7% inflation!! Employment remains strong, as we’ve recently seen as unemployment is now at 3.5%, job openings remain at 1.7/for every unemployed individual, initial unemployment claims have once again fallen, and wage growth is still >4% annually, despite some recent moderation. These all paint an incredibly healthy economic environment in which demand for goods and services will remain strong.
The Fed Governors have all been singing from the same hymnal, as they expect the Fed Funds Rate to continue to rise above 5%. None of the Governors expect any “pivot” in 2023. Where’s the disconnect? Again, most investors have not lived through a period of sustained inflation and rising rates. Recent aggressive Fed action has been undertaken from a base of historically low rates that were fueled by the pandemic. That level of rates was neither sustainable nor fundamentally driven. It was an action that needed to be taken given the circumstances. Getting to the current level of rates is more of a reset to where we were than a terminal point in the Fed’s war on inflation. As investors continue to fight the Fed, they are only making the Fed’s battle more challenging, which will likely lead to an even more aggressive Fed policy action. This battle has implications for US pension plan sponsors and their advisors. Should they stick with the status quo once again and hope that the Fed is wrong and that investors are right, or should they adopt a different approach that maximizes liquidity while buying time for the fund’s alpha assets to grow? I know what I’d do.
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