On September 21st, the Federal Reserve is expected to raise interest rates again, this time to a range of 3.0-3.25%. This will mark the highest Federal Funds Rate (FFR) since 2008. Most stressful for market’s isn’t the Fed’s act of raising rates, but rather the unknown with how high they will take them. We harp all the time on the idea of market’s being able to deal with known information very well. Surprises and unknowns is what causes sharp market sell-offs. In that vein, the great unknown right now is just how high the Fed is going to take the FFR. But it’s the market itself that keeps giving the Fed room to take the FFR higher and higher.
The relationship between FFR and 1 year Treasury
The FFR and the one-year Treasury rate track each other very closely. You can see this by looking at a long term chart of both:
Inversions of this curve, when the FFR has gone above the 1-Year treasury yield, have preceded each of the last 8 recessions. The Fed knows this history well. Fed Chair Jay Powell even said back in March that he watches this part of the curve much more closely than longer-dated ones. Therefore, we argue that the Fed will raise the FFR to the maximum level they can without inverting this curve. (The market currently thinks they’ll risk inverting this curve).
In other words, as the yield on the 1-year Treasury rises, the market is telling the Fed, “it’s okay, you can come up here too.” Herein lies the problem for stocks: the 1-year Treasury yield keeps rising. Thus, the market still can’t say with confidence just how high the FFR will go. Only when the 1-year Treasury yield stops increasing, or starts falling, will we likely see a sustained stock market rally.
The strongest rally this year
The strongest rally this year occurred from a stock market bottom on June 17th. Following that low, stocks rallied more than 15%. This rally occurred shortly after the 1-year Treasury yield fell and appeared to stabilize in a range around 3%. We would argue that the rally from that June low was due to the market’s belief that it finally knew how high rates would go.
Taking its cues from the 1-year Treasury yield, the market believed the Fed would likely stop its rate hiking cycle around 3.0%-3.25%. Again, in our view, it’s not the raising of rates that’s unnerving markets but the fear over how high they might go. When rates stabilized at a known level in late June and through July, this fear abated. The market started to “know” how high rates would go.
With that logic as our backdrop, it’s easier to understand why we’ve seen a renewed sell-off in stocks: beginning in mid-August, the 1-year Treasury yield started moving higher again. The yield pushed beyond that 3.25% high that the market thought was THE high. Thus, the cycle of not knowing how high rates will go started all over again, pressuring stocks.
With the 1-year Treasury yield now up to 3.95% it implies the Fed is likely to take the FFR closer to 4%. That’s substantially higher than the 3.25% rate that the market hoped was going to be the high just two months ago. Sure enough, the market now expects the FFR to be between 4.0-4.50% by the end of the year:
The good and the bad
The bad news is that stocks remain volatile as the market continues to adjust its rate hike expectations. The good news is things aren’t as bad as they were. Even with the market expecting much higher interest rates than it did back in June, stocks remain 7% above their June lows. That’s not much of a consolation prize when they are still down more than 15% on the year, but it is a fact and it’s worth noting. In addition, these higher yields spell opportunities for income oriented investors.
One reason stocks have not gone back to their June lows may be that the economy is on stronger footing than the market initially thought. For if it wasn’t, we might not see the market telling the Fed to take the FFR as high as it is. Said differently, if the economy wasn’t strong enough to handle even higher rates, the 1-year Treasury yield would not have moved from 3.25% to nearly 4% over the last three months. In effect, it would say, “STOP! YOU’RE GOING TOO FAR!” Right now, it’s telling the Fed that they can take the FFR close to 4% without breaking anything.
However, if the 1-year Treasury is still around 4% in December, and the Fed does raise the FFR over 4% as the market currently expects, that will invert the curve. And as we know, such an inversion has spelled recession every single time since the 1960s. So in that regard, the market does not currently have confidence that the Fed will stop raising rates before getting to a dangerous level for the economy.
What to watch from here
The 1-year Treasury yield gives us real time insight into where the market believes the Fed will take the FFR. We don’t believe the market is bothered by a nominal level of rates between 3-4%. Rather, the market is anxious that rates may have to go even higher, and that it doesn’t know just how high that level is. The best rally this year didn’t require a major decline in the 1-year Treasury yield. Instead, it just required stability at a known level, an ah-ha moment of sorts that the market could then work with and factor in to future assumptions.
Once the 1-year Treasury yield stops rising, even if that means staying stuck at 4%, then we’d expect stocks to rally. However, if this yield keeps rising, or if the market continues to believe that the Fed is going to take the FFR above the 1-year Treasury yield (and invert the curve), then any stock market rally may be in precarious position.
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