“Don’t fight the Fed.” Except, perhaps, when the Fed suddenly veers off their well-telegraphed course.
The first quarter of 2023 was characterized by apprehension. We started the year worrying about the looming debt ceiling debate, and the impact of the Federal Reserve’s interest rate increases and liquidity reductions. The Fed has been steadfastly combatting inflation, resulting in the fastest pace of interest rate increases in recent history.
Then Silicon Valley Bank happened. Rapidly rising interest rates took a toll on bond prices, which in turn significantly lowered the value of the securities (bonds) held at several banks. Those that held longer-term or lower credit quality bonds were particularly hard hit, and when depositors en masse requested withdrawals, Silicon Valley Bank and a few others came up short. The Fed and U.S. Treasury acted quickly to avoid contagion by injecting $755 billion into financial markets and offering specific safety nets to compromised banks. The Strategas chart below illustrates this change of direction clearly.
As we know from 2020 and 2021, large inflows of cash into our financial system boost markets, particularly the “risk-on” segments. The S&P 500 returned 7.5% for the quarter, but 90% of that return came from just ten stocks, all in the tech sector. The tech-heavy NASDAQ grew 16.8%. Energy, financials, utilities and health care sectors all lost value. Bonds gained 3% in the quarter.
The Federal Reserve is not done fighting inflation. In fact, this emergency cash infusion may have the side effect of increasing the prices they are struggling to control. However, economic data has begun to show signs of slowing that may give the Fed some comfort: Job openings finally fell under 10 million, for the first time since 2021. Global housing markets are weaker. Manufacturing is slowing, coincident with higher inventory levels. Corporate profit growth is waning and earnings’ estimates for the remainder of 2023 are coming down. The Fed’s primary inflation indicator is improving.
Ideally this evidence of a slowing, combined with the continued lagging effects of prior rate hikes, will be sufficient for the Fed to pause rate increases, guiding the economy into a soft landing or mild recession.