Markets generally do a good job of reflecting known information. So to understand why 2022 has been such a poor year, we just need to look back at what the market knew, or at least thought it knew, near the end of 2021. Heading into 2022, the market expected that the Federal Reserve would raise the federal funds rate to between 0.50-1.0% throughout the year. Those expectations became upended almost immediately once the new year began.
Today, the federal funds rate is at 4.33%, more than 300% higher than where the market forecast it would be one year ago. Higher interest rates have surprised markets all year and have been a catalyst for declining stock and bond prices. The good news is that the set up looks much different heading into next year.
Why the Fed’s rate matters
The Federal Reserve sets the federal funds rate (FFR). The FFR is the overnight lending rate that banks charge each other. To help keep the FFR where the Fed wants it, the Fed board sets something called the IORB, or interest on reserve balances.
The IORB is the interest rate that the Fed will pay banks for keeping their excess cash in an account with the Fed. So we have two rates:
- FFR: what banks are charging each other on an overnight basis
- IORB: what banks can earn from the Fed on an overnight basis
Consider the following example: if the IORB rate is 4% and the FFR is 3%, a bank could borrow from another bank (paying 3%), and then earn 4% by depositing that borrowed money with the Fed. This results in a 1% gain by arbitraging between the two rates. This example results in restrictive policy because it encourages banks to keep money with the Fed.
If the IORB rate was lower than the FFR banks would be incentivized to lend with each other since they could earn a higher return than what they would get from keeping money with the Fed. Such policy would be stimulative because it would result in more money flowing through banks and trickling into the economy by way of consumer loans.
How the Fed rates impact lending
Today, the IORB is 4.40%, which is 0.07% higher than the FFR. While not a meaningful difference, it still results in restrictive policy and sucks money out of the economy.
Why would a bank do any consumer lending if they could just keep money with the Fed and earn 4.40%? They wouldn’t. Or, if they would, they’re going to charge a premium over the IORB to make it worth the risk they’re taking.
This helps explain why mortgage rates have risen from 3% to over 6% this year. When the IORB and FFR were near 0% last year, the banks could embrace the argument of underwriting low rate mortgages, even if risk was involved. Because what was the alternative? Lend to the Fed and earn nothing? But now with Fed rates significantly higher, the math changes dramatically.
Every consumer facing loan the banks can underwrite is competing with a risk-free deposit the bank can make with the Fed. These mechanics tighten the money supply and slow down the economy. This is an intended consequence of the Fed’s inflation fighting mission.
The market got interest rates wrong in 2022
The problem for the market this year is it misjudged two key items:
- Its reliability on the Fed’s own forecast of “transitory” inflation
- Its perception of how committed the Fed would be to fighting said inflation
Consider this, one year ago, the debate in the market was if the Fed would MAYBE be able to raise the FFR to 1% by the end of 2022. By the end of January 2022, the market bumped its forecast up to 1.0-1.5%. From February to March, the market’s forecast rose from 1.50% to 2.75%. By the end of April the market’s projection had risen to 3%. It wasn’t until September that the market finally matched its year-end projection with where the federal funds rate would ultimately be set: between 4.0-5.0%.
Markets have rarely, if ever, had to reprice themselves for this level of interest rate hikes in such a short period of time. So it’s no wonder markets have been volatile in response as they consider interest rate policy becoming more and more restrictive than previously expected.
The set up is different heading into 2023
Because interest rates are entering 2023 so much higher than they entered 2022, there is less potential for a negative interest rate surprise by the Fed. To that point, markets currently expect the federal funds rate (FFR) to peak around 5% by June. This is in line with the Fed’s own projections for a peak rate of roughly 5.10%. Because the Fed hiked rates so aggressively this year, there will be very few hikes next year.
With that said, the market doesn’t even want the Fed to get to 5%. The latest sell-off in stocks started on December 14th, after the Fed emphasized their commitment to getting to that 5% target next year. The market would much prefer a ‘wait and see’ approach by the Fed here in order to assess the economic effects of all of the hiking they’ve already done. But, that’s not what the Fed says they’re going to do.
So if the Fed does go to 5% next year, it will likely cause more pain in the stock market. However, at this point that’s the consensus – for the first time in decades, analysts expect stocks to go down in 2023:
And here’s an important point: consensus creates expectations. And expectations create the baseline from which markets perform. Any realized deviation from those expectations upends market performance. Rewind once more to December 2021: markets expected an FFR in 2022 of 1%, which would still have been economically simulative. Instead, markets got an FFR of 4.33%… a major deviation from expectations. The result? Market performance was upended for the worse, and stocks are on pace to register an annual decline of 20%.
Will stocks go down 20% again next year? I doubt it. And that’s because we’re unlikely to have such a drastic deviation from what the market currently expects. That’s the benefit of going into next year already at an FFR of 4.33%. In fact, next year we could see the opposite effect: where markets expect the Fed to keep interest rates between 4-5%, but instead they lower them towards 3%.
Why would the Fed lower interest rates next year?
If the economy weakens more than expected, the Fed is in a good spot to offer support. Just as their interest rate hikes restrict economic activity, they could move to stimulate the economy by cutting rates. This is why going into 2023 at an FFR of 4.33% is so important: the Fed can offer 1.25% of interest rate cuts, and only be back down towards 3%.
Now, the real debate in the market isn’t IF the Fed can support the economy in a slowdown with interest rate cuts. No, the real debate is if the Fed WILL support the economy in a slowdown with interest rate cuts. At the moment, the Fed is sticking to a party line of ‘higher interest rates for longer‘ because they remain fearful of high inflation. It’s hard to know if the Fed’s tough talk right now will match the actual policy they implement in 2023.
Post 2008, the market has had success in forcing the Fed into market friendly policy decisions. This became known as the “fed put” or the idea that if stocks fell far enough, the Fed would step in to buoy markets.
For example, in 2013 when the Fed hoped to end its bond buying program, the market sold-off, in what became known as the ‘taper tantrum.’ In 2018 when the Fed was hiking rates into a slowdown, stocks sold off 10%+ that December. The Fed then announced a pause in their rate hikes and stocks rallied throughout 2019. In 2020, when the government implemented lock downs to fight the outbreak of Covid-19, the market sold-off aggressively. This prompted emergency measures by the Fed which put a bottom in the market.
Due to decades high inflation, there is concern that the Fed can no longer be forced into market friendly policies the way it was when inflation was under 2% (like throughout much of the 2010s). In other words, the Fed had the market’s back for the last 14 years, and now it doesn’t.
What drives markets in 2023?
The market in 2023 will continue to be driven by Fed action. But instead of how high the Fed will go with rates, the market is concerned that the Fed stays high, even in the face of a slowing economy. Thus, the performance of the market largely hinges on two main factors, one coming before the other:
- Does the economy stay steady?
- If it doesn’t, does the Fed move to cut rates and support the economy?
If the economy stays steady then we should see a solid year for stocks in 2023. The odds on expectation is that a slow down is underway, with downside risks to the economy increasing. So any upside surprise to the economy, will be welcome news for markets and should spark rallies.
If the economy falters, as the market currently expects, the spotlight will again turn to the Fed. A slowing economy without Fed support likely sees stock prices remain under pressure in the new year. However, a slowing economy that prompts the Fed to reverse some of its recent rate hikes would likely see markets move higher. Such a scenario would be interesting in that stocks could rally even as the economy slows down and unemployment rises. Needless to say, 2023 is not shaping up to be a boring year. Whether that’s a good thing or a bad thing remains to be seen.
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