By Chris Puplava
Chief Investment Officer, Financial Sense® Wealth Management
May 25, 2022
Including 2018, this year will be the second time in history where the Federal Reserve is both hiking interest rates and shrinking its balance sheet at the same time. As is often said, the Fed raises rates until something breaks, which is typically reflected in the financial markets as they discount future economic reality. The fourth quarter of 2018 was that breaking point in the last hiking cycle and current market readings are hinting that the breaking point may be occurring now with a Fed pause starting to come into view.
The 2018 Tightening Cycle
The financial markets not only discount future trends of economic growth, inflation, and corporate earnings, but also monetary policy. The best gauge of understanding what the markets are expecting for future Fed policy is by looking at the futures market to see where market participants expect the Federal Funds Rate (FFR) to be in the future. When we look back at how things played out in 2018, we find that the peak in Fed policy that the markets were discounting looking out a year was in October of 2018 when the market was betting that the FFR would be 2.815% by October of 2019.
At the time, the current FFR was 2.25% so the market was essentially pricing in just over two quarter point hikes by the Fed in the coming twelve months. October 2018 was significant as that was when the market began to enter a correction, and with the decline in the stock market came a decline in the market’s expectations of future Fed policy. Two months later as we ended 2018, the market was no longer pricing in rate hikes in the following year, they were starting to price in rate cuts in stark contrast to the Fed who was still forecasting two rate hikes in 2019.
By the first week of January, after a 20% peak-to-trough decline in the S&P 500, we got the ‘Powell Pivot’ in which Fed Chairman Jerome Powell indicated the Fed would do whatever it takes to stabilize markets. The change in tone was a complete 180-degree turn from comments by Powell at the final 2018 FOMC meeting on December 19th and the bottom was in and the S&P 500 soared.
The 2022 Tightening Cycle
Looking at the current situation, we clearly are a long way away from the market discounting rate cuts in the coming 12 months, but it is starting to look like we may have seen a peak in expectations for Fed rate hikes. Currently, market-based projections of where the FFR will be next May peaked at 3.3% and appear to be rolling over at the 3% level.
Jeff Gundlach has argued that we should do away with the Fed and replace the fed funds fate with the 2-Yr US Treasury (UST) yield given its track record and there is a lot to be said about that argument. Typically, when we see the 2-Yr UST yield dip below the upper bound of the FFR, the Fed is done raising interest rates and pauses its rate hiking campaign.
This is exactly what we saw during the 1986-1989 cycle where there were no more rate hikes once the 2-Yr UST yield dipped below the FFR. The same goes for the 1993-1995, 1999-2000, 2004-2006, and 2015-2018 cycles.
Currently, the 2-Yr UST yield is roughly 1.5% above the FFR but if the Fed sticks with its 0.50% hikes in the next two meetings as expected, the FFR will be 2% by July and only 0.50% below the current 2-Yr UST yield. Should the 2-Yr UST yield continue to dip, we may see it fall below the FFR by August-September, which is a suitable time to expect a Fed pause.
Market Outlook
During the 2018 cycle, the S&P 500 bottomed on December 24th, a week before the official Fed pause. Our expectation is that if the Fed talks tough in the face of a continued slowdown, the markets are likely to weaken further and is why we remain defensive currently. The data shows the Fed is raising rates into a slowing economy and there is a good chance that long-term interest rates have peaked as they move from focusing on rising inflation and tightening Fed policy to an economic slowdown ahead. In the 2018 experience, long-term UST rates peaked in early November and then fell materially for the remainder of the year and well into 2019 as US economic growth began falling late in 2018 even with the Fed still tightening monetary policy.
Our first action in anticipating a turn in Fed policy was the recent purchase of long-term USTs for the bulk of our clients by picking up the iShares 20+ Year Treasury Bond ETF (TLT). Our next likely action is to begin the process of scaling back into the equity markets in the coming months as we start to see Fed rhetoric begin to soften where it is likely the Fed will be hinting at a coming pause through comments from various Fed governors.
If we are correct that a Fed pause is coming in the next 3-4 months, we believe reduced expectations for Fed policy will likely lead to a significant top in the US Dollar (USD), which hit a two-decade high earlier this month. Should our USD prediction become validated, we are likely to see increases in the prices of precious metals which we have clients currently exposed to. A top in the USD would also likely lead to general price increases in commodities as the two typically move in opposite directions. Should, at the same time, China begin to remove their lockdown measures, we could see global demand for commodities rise and put further pressure on commodity prices to the upside.
To hedge clients against this development, our plan in the coming months is to increase our exposure to commodities on weakness, with a particular emphasis on energy given the tight inventory dynamics currently. In our balanced accounts, we reduced our energy exposure in recent months as the market leaders tend to fall the most in the final phase of a market decline. This is due to a pickup in margin calls which leads to forced selling of what you can sell, not necessarily what you want to sell, as well as elevated fear levels that lead many to sell everything and go to cash, even their winners.
We want to wish you a safe and happy Memorial Day weekend and if you have any questions regarding your portfolios or our strategy, please do not hesitate to reach out to your wealth manager.
Advisory services offered through Financial Sense® Advisors, Inc., a registered investment adviser. Securities offered through Financial Sense® Securities, Inc., Member FINRA/SIPC. DBA Financial Sense® Wealth Management.
Copyright © 2022 Chris Puplava