The Fed at Work
September 23rd, 2022
It was a brutal week for markets as the Federal Reserve announced its third consecutive 75 bps hike at the conclusion of its 2-day FOMC meeting on Wednesday. Wednesday’s hike marked the central bank’s fastest pace of monetary tightening since the early 1980s, and at a targeted range of 3.00% to 3.25%, the fed funds rate now stands at its highest level since 2008. Despite having accurately anticipated the size of the rate hike, markets were initially unsure how to respond – first falling, then rallying and finally plummeting once the full weight of the Fed’s commentary and economic projections were synthesized by investors. By week’s end, the ten-year treasury yield had surged to 3.829% and the 30-year fixed mortgage rose above 6.50%. Domestic equity markets fell in tandem, with the S&P 500 shedding -4.65%. For the rest of the world, the week’s news was even worse. The UK perplexed markets by raising rates by 0.50% to combat inflation while announcing a massive tax cut bill, which many worried would only contribute to inflation. Meanwhile, the EU, suffering from declining business activity, the lowest consumer sentiment since records began in 1985, and a looming energy crisis, faced new risks as Russia mobilized its military and renewed its nuclear threats. The totality of the week’s news managed to erase any remaining optimism over the prospects of a soft-landing, and instead had investors bracing for impact.
Fed Up with Inflation
The Federal Reserve continued its inflation fight, tacking on another 75-bps hike to the fed funds rate in an effort to help curb demand and ease prices. The latest hike pushed the central bank’s benchmark lending rate to 3.00% to 3.25%, a level not seen since 2008. Although markets had fully expected the Fed to hike 75 bps, they were caught flat-footed by changes to the central bank’s future projections. The dot plot, which graphs each Fed governor’s future monetary policy rate, showed the consensus fed funds rate rising to 4.40% by year-end. That was a full 1% higher than June’s projected estimate of 3.40%. The Fed also increased its terminal rate (point where officials think they can stop raising rates) to 4.60% in 2023, up from a previous forecast of 3.80%. Once hitting the terminal rate, the Fed now expects to hold rates steady for much of 2023 before pivoting to lower rates in 2024. Needless to say, markets did not take the news well. Investors have been accustomed for years for the Fed to make a quick pivot to lower rates at the slightest sign of slowing economic growth. That no longer seems to be in the cards as the Fed remains firmly focused on maintaining its inflation-fighting campaign. The updated dot plot projections is a response to the recent uptick in core inflation, and while it shows that the Fed means business when it comes to tackling inflation, the rate of change caught markets by surprise.
Rising Borrowing Costs Chill Housing Market
The housing market struggled once again in August as a series of Fed rate hikes pushed mortgage rates higher throughout the summer. Existing home sales fell -0.40% to a seasonally adjusted annualized rate of 4.8 million units. That was their slowest pace since June 2020. Year-over-year, sales were down -19.90%. Despite the drop in overall sales, the concentration of sales at the upper end of the market continued to push the median price of a home higher. YOY, the median price of an existing home sold in August rose 7.70% to $389,500. Supply still remained tight at 3.2 months. By comparison, six to seven months supply is considered to be a healthy balance between supply and demand. With rates expected to continue to rise, leading to decreasing affordability, more sellers are looking to keep their houses off the market. In August alone, the number of newly listed homes fell -13%. The move could have the unintended effect of softening sales while continuing to keep prices elevated. New construction also showed further signs of softening ahead. Ground-breaking on new homes in August rose a seasonally adjusted 12.20% in August to 1.58 million. The increase reverses July’s -10.90% decline. However, the construction pace was driven primarily by volatile apartment building which rose 28.60% month-to-month. Single-family building rose a more modest 3.40%. The outlook for new construction looks weak as building permits for multi-family and single-family fell -18.50% and -3.50% in August, respectively. With borrowing costs for builders and homebuyers set to rise, builders look likely to further slow construction in the months ahead.
Final Thoughts
Any time you have a big macroeconomic news week like we had this week, it makes sense to take a step back and reassess the bigger picture. That goes double on weeks with big losses. If we think about this week’s market performance, we were of the belief that the economy was running too hot on any number of metrics (employment, inflation, spending), and the Fed’s and the market’s rate projections were probably too low to inflict the type of discomfort necessary to change behavior and blunt inflation. Equities were fairly valued given the uncertainty over a recession, and bonds were approaching, but had not quite reached, what we’d consider normal levels. No matter how you cut it, the Fed’s 3.8% terminal rate coming into the week was still cheap money. Now with the Fed predicting a 4.6% terminal rate, along with the spreads attached to that base rate for the various types of loans utilized within the economy, we think this will finally have a material impact. One really starts to think twice when you are borrowing at 6-7% on mortgages, and when credit cards are charging 22%! So, while the Fed’s shifting expectations may have come as a surprise, it really shouldn’t have, and the new rate path is not only necessary to control inflation but finally an honest projection. It probably takes a 4.5-5% risk-free rate to reduce demand and with the most recent dot plot, the Fed now expects to be in that range at its apex. That is good, and despite the market not liking it, investors now have that target to wrap their heads around and to move on. So, we think the Fed has now set a realistic path forward. The next question is will it be effective and how long will it take? Setting aside the possibility of an outlier (i.e. Europe having an unusually cold winter, nuclear conflict with Russia, new strain of Covid inducing lockdowns), the Fed sees inflation cooling over the next 18-24 months. That seems reasonable given the rate levels we’re now talking about. So, it seems we now have both the “fix” and the timeframe for the fix pretty well defined. This then leads to the final, and admittedly more difficult questions, which is what are the consequences, and how far do financial markets need to correct based on these estimates? On the bond front, we’re likely approaching a bottom. Rates have now risen to levels not seen since 2010. Rates are above those seen during the taper tantrum, the Greek Crisis, and approximating levels seen just prior to the 2008 Financial Crisis. A full analysis is beyond the scope of our weekly newsletter but with rates on investment grade corporate bonds having risen nearly 3% this year, we are probably 0.25-0.5% away from what we’d consider very attractive levels. All this to say, the bottom for bonds is probably not far off. On the equity side, it’s likely to be volatile for a while, and we probably have a recession to contend with. Equities will likely perk up, however, once the Fed pauses and certainly once the Fed begins cutting. The Fed is likely to pause in 2023 and cut in 2024, and as we wrote in June when we were at similar levels, we believe another 10% decline from here would make equity markets extremely oversold. In conclusion, we view the Fed’s new projections not as a surprise but as being more realistic, giving us a better understanding of the overall timeframe and giving us greater confidence to begin undertaking some of the durations and yield transitions within portfolios that we’ve been contemplating for some time now.
The Week Ahead
Investors close the books on a volatile third quarter with hopes markets can re-gain their footing in the last trading quarter of the year. Economic news will be relatively light with durable goods and consumer spending and personal income being the highlights of the week.
Researchers Use Drug Repurposing to Find Promising New Treatments
Sometimes the medical community or patients themselves notice an unanticipated beneficial effect from a drug. One example is a drug that was developed to treat chest pain from coronary artery disease, however, that drug failed clinical trials but when researchers observed one of its side effects, the drug known as sildenafil was rebranded and sold as Viagra. Additionally, a drug called eflornithine that was found to be ineffective against cancer in trials, was later found to cure a parasitic infection called trypanosomiasis, or sleeping sickness.
There are approximately 2,500 FDA-approved drugs, and an average of 46 new drugs are approved each year. However, more than 90% of drugs that enter clinical trials end up failing, with billions of dollars of research and development seemingly going down the drain.
However, a process known as drug repurposing came into the spotlight when the COVID-19 outbreak happened, as scientists in the U.S. and elsewhere raced to find treatments for the disease among tens of thousands of available drugs, including those that had been researched but did not pass clinical trials – either because they didn’t adequately treat the condition they were meant to target, or the side effects were too strong. Jonathan Sexton, assistant professor of internal medicine and medicinal chemistry at the University of Michigan, who specializes in drug discovery and development, tested 1,425 existing, FDA-approved drugs in human cells that were infected with COVID-19, including some dietary supplements to determine if they were effective against the disease.
Sexton’s team found 17 repurposing candidates for further examination. Several of the leads his team identified have since entered preliminary clinical trials, including drugs originally intended to treat leprosy and prostate cancer. The team ended up pulling a supplement called lactoferrin off the shelf as well. Lactoferrin is an iron-binding protein that is present in the milk of the majority of mammals, including cows, thus it is found in products such as ice cream. Bovine lactoferrin exhibits broad-spectrum antiviral properties against many microbes, viruses, and other pathogens. Sexton reported that lactoferrin consistently produced promising results in their COVID studies, but with many caveats. The findings were published in separate papers in 2021 and in 2022.
Apparently, science shows that milk does a body good, however, here’s where the caveats come. Sexton reported that patients would have to drink gallons of milk per day to have a possible beneficial effect, which would have undesirable consequences, such as obesity, which is a risk factor for severe COVID disease. He cautions that his team has not determined clinical efficacy yet, and he is not offering advice as a physician. Along with the previously mentioned clinical trials, Sexton is currently working on testing a chewing gum formula to fight COVID that might release enough lactoferrin to inhibit replication and give the immune system a chance to knock out the virus before it can establish a foothold. It may also reduce the amount of virus spread through talking. A “challenge trial” to help test these theories would involve exposing thousands or tens of thousands of volunteers to the pathogen that causes COVID over a period of months or even years. It would also be expensive, and the FDA has been hesitant to approve such trials involving human subjects. Nevertheless, we thought this might provide some therapeutic inspiration heading into the weekend, particularly for those who might love the idea of possibly being able to “lick” COVID someday.