Waiting for the Fed

After a month-long rally, which pushed the Dow up 14% and the S&P 500 up 8%, investors are taking a breather. This morning’s trade is choppy and directionless ahead of the Federal Reserve’s policy announcement tomorrow. October wasn’t a great month for bond investors because rising interest rate expectations hit bond prices. The 2-year Treasury Note yield climbed to 4.53%.

October brought some clarity on the economy. It’s not deteriorating fast enough to suit the Fed. That may sound odd, but remember that all the interest rate hikes are aimed at slowing the economy so that inflation calms down. There are some clear signs that Fed policy is working. For example, manufacturing activity is stagnating, according to the Institute of Supply Management (ISM). Rising interest rates and growing uncertainty about the economy are pushing companies to begin preparing for lower demand. And predictably, manufacturers are reporting a sharp drop in cost inflation. In addition, homebuying (and building) activity is slowing sharply, causing home price growth to stagnate.

But the lion’s share of the economy has been resilient in the face of Fed policy. The job market remains pretty tight and wages are still rising at a roughly 5% clip. Banks and credit card companies tell us that consumers have more money on deposit than they did pre-Covid, and spending remains healthy. Finally, Corporate America isn’t yet breaking under the pressure. Aggregate sales & profit growth for S&P 500 companies during the third quarter were each about 11%.

This strength is sort of unwelcome in the Fed’s eyes, and implies that they’ll have to continue raising rates in order to ultimately subdue inflation. Investors expect the Fed to announce another .75% hike tomorrow, bringing the Fed-funds rate to 4.0%. Bond traders expect that rate to climb to nearly 5% by May. The higher rates go, the more likely we’ll suffer an economic recession. (Debt fuels growth, but high borrowing rates discourage us from taking on debt.) Fed officials know this, of course, and they also know that it takes time for higher rates to have the desired impact on economic growth and inflation. So at some point they’ll stop raising rates and allow some time for monitoring the trajectory of inflation. The question is when. Investors are hoping for some hint of a pause in tomorrow’s announcement.