Stocks May Plunge Further With The Fed Facing Policy Challenges (SPX)

We have clearly entered a new period in the monetary policy cycle, which could be summed up as feeling your way through it. It seemed pretty clear from an interview on October 19 with Jay Powell at the Economic Club of New York that the Fed isn’t sure how far rates may have to rise, how long they may have to stay high, or where the longer-run rate may be.

What is also clear is that the Fed doesn’t even know if rates have been high enough for long enough yet or if we have or haven’t seen the full effects of monetary policy yet. It also seems to be the case that Powell doesn’t think that policy is too tight at this point.

Uncertain Path

Overall, if the data stays strong and signs of inflation creep back in, the rate hiking isn’t over, and there could be more rate hikes. It also means that if there are signs of some slowing, the Fed won’t be so quick to cut rates due to the fear that inflation will come back, while it is also hard to know if keeping rates too high does unneeded harm to the economy.

Today’s dialogue made it perfectly clear that will only rise if needed, and rate cuts aren’t likely to happen anytime soon.

Overall, the bond market seemed to take the message exactly as intended from Powell. The result was a 30-year rate exploded higher to reach 5.1%, and the 10-year increased to 4.99%. The 2-year rate moved slightly lower as it adjusted for a potential short-term pause from the Fed, allowing the yield curve to bear steepen, which is when the back of the curve rises to the front of the curve.

The Treasury yield curve appears to be normalizing as it prices out the odds for a US recession and comes to grip with, and prices in, a neutral rate that may be higher than previously thought to be. If the yield curve is normalizing, it means sloping up and to the right, implying that rates at the back of the curve still have much further to rise from current levels to reflect where Fed monetary policy is set.

Equities Do Not Seem Happy

Unfortunately, the equity market is also coming to grips with interest rates rising and doesn’t like it. Remember, the equity market back in the spring was convinced that rate cuts were coming because inflation was melting away.

It turns out, as noted several times, that was wrong. Inflation hasn’t melted away; it is sticky, the biggest risk to stocks is interest rate risk, not recession risk, and the Fed is serious about staying higher for longer.

Valuing stocks against bonds is not easy, and what has worked in the past doesn’t always work in the present or future. But what is clear is that the spread between the Nasdaq 100 earnings yield is about 310 bps lower than where it averaged for nearly a decade and is back to the lows last seen at the stock market highs of 2006 and 2007.

Spreads Have Narrowed

Now, the collapse in the spread could be because investors view some stocks as a safer investment than bonds, given the losses witnessed in the bond market. However, rates tend to move together, and stocks have been just a derivative of the bond market and trading with credit spreads for some time.

Over the last few months, it wasn’t only stocks that saw spreads narrow with Treasury rates, but high-yield junk bonds did as well. The Bloomberg High Yield Average Option Adjusted Spread fell to levels consistent with times in 2016, 2017, and 2018.

The odd part is that if investors fear owning bonds and Treasuries are considered “risk-free,” why would an investor pay a premium for a bond considered junk relative to a “risk-free” asset with a higher risk of default or losing even more value? The only reason one might be willing to do that is if they believe rates on the Treasury curve are too high and will come down.

If it is the case that high-yield bonds carry more risk than Treasuries, and now knowing that rates on the long-end aren’t only higher than they were in the summer but may still be at risk of going higher. One would think high yield rates would rise, too, and even trade at a more significant discount, widening the credit spread.

Knowing that stocks and spreads tend to trade together, one would think that as high-yield credit spreads widen, the earnings yield or the dividend yield for stocks should also increase, pushing stock prices down.

So one has to think as the market continues to go through this process of adjusting to a Fed that has every intention to leave rates higher for as long as needed, and even better, isn’t sure just how high that may ultimately be or isn’t sure just how long that ultimately be, or if rates are even tight enough currently, probably means that normalization process has only just begun.