Ukraine’s aggressive response to and subsequent repulsion of Russian troops surprised everyone, not least Vladimir Putin. However, as March came to a close, negotiations were beginning to be more realistic, and the evidence on the ground was that Russia was retreating and reassessing.
The Federal Reserve held the monthly FOMC meeting and raised the key short-term interest rate by 25 basis points. What wasn't expected was Fed Chairman Powell's subsequent remarks about the pace of rate increases. Powell has worked to be transparent and proactive in communicating the Fed's intentions.
The change in the pace of rate increases was clear in his language "There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level, and then move to more restrictive levels if that is required to restore price stability."
Markets interpreted that to mean that 50 basis point hikes would be deployed at the next round because the language change was from raising rates "steadily" in January, which the Fed translated to 25 basis point rate increases.
What Powell is attempting with the return of monetary policy to a "neutral level" is to raise rates as high and as quickly as possible, to take excess liquidity resulting from stimulus out of the system. At the same time, the labor market continues to be very strong. If further rate hikes are necessary to lower inflation, in theory, the Fed will have more control as it balances rate increases and supports a growing economy.
The reaction?
Equity Markets: Cool. Growth. We’re Good.
Bond Markets: Not the 50 bps - INVERT THE YIELD CURVE!
The New Recession Obsession
After flirting with the flip for the last week of March, the yield curve inverted on April 1st.
What does this mean?
A standard curve of the different yields related to the maturities of U.S. Treasury securities rises as durations get longer, so the 30-year U.S. Treasury pays a higher yield than the 3-month U.S. Treasury because of the risk of holding the longer-term instrument. The yield curve "flattens" when the spread narrows between a pair of rates, for example, the 5-year and the 30-year. When the shorter-term rate rises above the longer-term rate, the curve is said to "invert."
Essentially, when short-term rates are higher than long-term rates, bond investors are betting that the economy will slow in the future.
Why do people that aren’t bond traders care?
A recession tends to follow when the yield curve inverts for an extended period. Not right away – it's usually months or even years before the economy catches up to the bond market's signal of no confidence. But as an indicator, it's pretty accurate. However, we are in it for the long term!
What About This Time?
The inversion was triggered by the release of the very strong March employment number. The March non-farm payroll increase was 431,000 jobs, which pushed the unemployment rate to 3.6%, from 3.8%. The fifty-year low unemployment rate is 3.5%, which we hit just before the pandemic. The idea is that the strong labor market means that the Fed will be forced to enact a series of 50-basis point cuts, leading the economy into recession. The significance of the 50-basis point cut is that we haven't seen one in 22 years. But that's just one scenario.
Rates all along the curve are not inverted. The Atlanta Fed plots the markets’ expectations for the Fed funds rate. The calculations show a rate that peaks at 3% in the fall of 2023, then drifts slowly downward to 2.5% by the spring of 2025. This looks like the 2019 yield curve inversion, which was followed by some gentle "mid-cycle" rate cuts that worked.
Chart of the Month: GDP Expectations Have Been Revised to Reflect Ukraine
Projected GDP Change in G-7 Countries
Source: Data: Economist Intelligence Unit; Chart: Will Chase/Axios
Equity Markets
The S&P 500 was up 3.58% in March, bringing its YTD return to -4.95%
The Dow Jones Industrial Average rose 2.32% for the month and returned -4.57% YTD
The S&P Mid-Cap 400 increased 1.21% for the month resulting in a -6.22% YTD return
The S&P Small-Cap 600 gained 0.18% in March, putting the YTD return at -5.93%
Source: All performance as of March 31, 2022; quoted from S&P Dow Jones Indices.
Bond Markets
The 10-year U.S. Treasury ended the month at 2.34%, and the 30-year U.S. Treasury ended at 2.45%. The Bloomberg U.S. Aggregate Index was down, returning to -2.77%. As represented by the Bloomberg Municipal Bond Index, Municipal bonds returned -3.24%. High-yield corporate bonds struggled with rising rates, with a return of -1.14% for the Bloomberg U.S. High Yield Index.
The Smart Investor
Volatility is likely to remain elevated. At Hampton Park Financial Planning, this means deploying dollar-cost averaging strategies if you intend to contribute an annual bonus or tax refund to your investment accounts. While the Fed is series about fighting inflation, it will take time. So be sure you have enough cash in your accounts to cover the cost of higher spending.
While your debt has likely already become more expensive, don't expect interest rates on savings, checking, or money markets accounts to jump up overnight. Cash is still costing you money, so anything beyond what you need for expenses may be better put to work in other investments.
This isn’t the time to make significant changes to your long-term investment plan. Bond yields aren’t high enough to outpace inflation, and rate increases mean the prices of longer-duration bonds are struggling. At Hampton park Financial Planning, we review this information often and are here to be your second set of eyes.