We’re Fighting the Fed

We’ve written before that stocks predict the future. However, the bond market has much better accuracy.

On Wednesday, the U.S. Federal Reserve increased interest rates yet again in its effort to combat inflation. After this week’s 25 basis point hike, the Federal Funds Rate now ranges from 4.50% to 4.75%.

Usually, however, the yield on the 2-year Treasury indicates where the Fed will ultimately settle. Around late September 2022, the 2-year yield stopped going up. Since then, it has flatlined. As of this writing, the 2-year accompanies a yield of 4.20% (far less than the Federal Funds Rate).

The 2-year Treasury is below the Federal Funds Rate because the bond market is calling the Fed’s bluff. In other words, it expects the central bank to cut rates before the year is over. In fact, expectations are for a rate cut to happen as soon as this December.

We agree with the bond market.

It comes as no surprise that the Fed has a credibility problem. Their rhetoric doesn’t accompany much assurance of anything. Keep in mind that in his annual speech at the Jackson Hole symposium on August 27, 2021, U.S. Federal Reserve Chair Jay Powell said:

Incoming data should provide more evidence that some of the supply–demand imbalances are improving, and more evidence of a continued moderation in inflation, particularly in goods and services prices that have been most affected by the pandemic [are forthcoming].

Things worked out quite differently.

Frankly, inflation grew out of control.

The Federal Reserve is not a leading indicator. To the contrary, the central bank is usually late to the party and then overstays its welcome. For that reason, we pay much closer attention to the bond market’s activity than the words spoken by any of the Fed officials.

Stocks and interest rates often move in opposite directions. An end to this rate hiking cycle will be welcomed news for investors.