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The Federal Reserve recently kept interest rates at the same 5.25% level for the first time in 13 meetings (roughly one per month). Does this mean we have reached the peak in interest rates? Likely not.
Core inflation remains a problem for the Fed. It has come down far slower than they thought it would, let alone being simply “transitory” as was thought a couple of years ago. The cessation in rate hikes, along with the debt ceiling drama vaporizing, has caused the stock market to shift into another gear recently.
We don't think the market has to give back all of the recent gains, but we do believe investors should expect some hiccups and decent-sized drawdowns as we progress, spurred by shifting expectations for Fed moves and incoming economic and earnings data. We think these are conditions long-term investors can lean in to, buying dips, and proactively rebalancing.
Last week’s inflation report showed headline inflation coming down nearly a full percentage point from 4.9% to 4.0%. That is progress. Unfortunately, it was mostly due to a drop in energy prices, and something called ‘base effects.’
Headline inflation figures are influenced significantly by movement in energy (especially gasoline) and food prices. Gas prices have come down sharply in the last year helping to drag down inflation.
Base effects are simply the number current prices are compared to. For example, the calculation of the inflation figure is very simple. They take the current price and divide it by the year ago price. I know: rocket science!
Base effects are the rolling off of the year ago numbers. If we look back at the figures from
May and June 2022, we can see that there were some large increases in Consumer Price Inflation (“CPI”). As those figures roll off, the increases are incorporated into the index, and it has the natural effect of reducing inflation.
For example, in the chart below, we see the monthly CPI figures including the index, year over year inflation rate, and month over month inflation rate. The year over year is calculated by dividend the May 2023 index (304.1) by the year ago (292.3) = 4.0%.
In the last column, the month-over-month, we are calculating the one-month change in the index. You can see that May and June of 2022 were big up months for inflation- with the peak rate hitting 9.1%. Since then, headline inflation has been falling.
Thanks to that base effect, when we get the CPI report next month it will show another large drop as the June 2022 figure falls off.
The problem for the Fed is not headline inflation, but Core inflation. This is the same calculation without the volatile food and energy price moves.
There is also something called “super core” which takes Core inflation and takes out housing rents.
It’s not like people spend money on any of those things, right?
Core inflation has been stickier than headline since it hasn’t benefited from falling energy prices like headline inflation has. Additionally, the calculation of the housing/rents figure is a bit complex and lags real housing prices and rent rates by as much as six months.
Housing has remained a sore spot for the Fed as their attempt to cool the housing market has largely failed despite mortgage rates topping 7%.
The issue is that supply remains very low keeping a floor under housing prices. We have underbuilt housing over the last decade (thanks to the Financial Crisis of 2008) and experienced some technological shifts (think Airbnb growth) where investors have bought homes by the thousands with the goal of renting them out.
This was a natural by-product of low interest rates of the last decade as investors sought other avenues outside of bonds.
Core Inflation is coming down, but it is much slower (see chart).
The Fed has been focused on these Core inflation figures and given the slow decline, is likely to boost interest rates a bit more from here.
Right now, the market expects a 75% chance that the Fed raises interest rates by 0.25% next month.
There is also a small chance of another 0.25% hike after that. Then the market thinks the Fed will be done.
Unfortunately, Core inflation doesn’t seem to move lower significantly unless the Fed Funds rate is well above Core inflation (see chart below).
Another two rate hikes, which are not assured, would push Fed Funds about 0.5% above Core inflation and really help move it lower.
It will take some time before Core inflation gets close to the Fed’s 2.0% inflation target – likely well into next year. At that point, the Fed will lower interest rates back to neutral at a moderate pace.
This means that bonds issued with coupons/ yields at today’s rates will be worth much more. Think about how bonds work and the relationship between price and rates. As rates fall, bond prices move higher.
An investor who is buying a 6.0% bond would pay far less for a bond paying 3.0%. The market will equalize the prices so that the yields are nearly equivalent.
This is why we are buying individual bonds with these yields and longer maturities – so we can lock in these yields for our clients for many years to come.
We have a once in a generation opportunity in fixed income. Bonds are yielding 6% or more with much less risk than what investors were buying just a couple of years ago.
We have been buying, in some cases credit-risk free bonds that pay 6.3% or higher and are state income tax free.
High quality investment grade corporate bonds are paying 6.5% to as much as 8.0%. If we can lock that in for as much as the next decade, it would mean financial plans that assume 4.5% - 5.0% returns will be much healthier and place less load on the stocks to produce higher returns.
As always, we value the confidence you place in us.
Mark J. Asaro, CFA
Noble Wealth Management