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Investment Commentary

What Changed So Much Since February 1?

By Brian Andrew | Johnson Financial Group • February 24, 2023

4 minute read time

When the Federal Reserve met at the beginning of the month, it increased the Fed Funds interest rate by another quarter of a percentage point. Since that meeting, the yield on a 2-year Treasury bond has risen by 15%—from 4.09% to 4.69%. The 10-year Treasury yield has risen by about the same percentage, moving from 3.40% to 3.92%. What was so important about that meeting that bond yields have risen so much in such a short time? What changed?

This week, The Fed released the minutes of that meeting, providing insight into its decision to raise rates and perhaps some explanation for the bond market’s repricing of bond yields.

More insight from the meeting minutes

Ahead of the Fed’s last meeting—and its rate-hike announcement on February 1—bond investors had begun to believe the Fed’s forecast for interest rates was too high. As a result, they pushed rates down (causing bond prices to rise) since the beginning of the year. These investors became convinced that a weaker economy would provide the Fed some room to stop raising rates sooner and begin lowering rates later this year.

Unfortunately, the economic data has proven to be more resilient. Job growth has remained very strong, retail sales have been better than expected, and lower interest rates have modestly buoyed the housing market. And, while inflation has been in decline for months, the current rate is still almost three times the level the Fed would like to see. This led the Fed’s Chairman, Jerome Powell, to reiterate the Fed’s desire to fight inflation with additional interest rate hikes and maintain a higher rate for longer than investors expect.

The Fed released its meeting minutes on Wednesday of this week. The minutes corroborate Powell’s message and the view of the Open Market Committee, which expects reducing inflation will “take some time.” The Fed is prepared to leave interest rates higher for as long as necessary. The minutes indicate that “inflation data…over the last three months showed a welcome reduction in the monthly pace of price increases but stressed that substantially more evidence of progress…would be required to be confident that inflation was on a sustained downward path.”

Stock returns

Since the beginning of February, as bond investors reevaluated the Fed’s position, stock prices have declined. Since the first of the month, the S&P 500 Index has lost 2%. Not a big move after the January rally of 6%. It does, however, reflect the fact that stock investors continue to worry about the absolute level of interest rates in addition to the future earnings potential of companies.

Companies borrow money through the bond market and from banks. Those borrowing costs are a direct reflection of the level of interest rates. As rates rise the cost of capital rises with them. The Fed giving the signal that rates could remain higher for longer suggests to stock investors that the cost of capital may remain elevated for some time. Thus, their expectations for earnings growth could be overstated. It is too early to tell how this will play out. It is important to understand the relationship between bond and stock investors as both keep an eye on the Fed for future cues.

Bonds are back

We have to recognize that while bond returns were awful last year, the fact that interest rates have risen is a good thing for the balanced portfolio. First, cash positions generate a real return now. The six-month Treasury Bill has a yield near 5%. This yield was near half a percent over a year ago.

What this means for a balanced portfolio is that bonds will once again be able to provide the diversification effect they’re meant to in a volatile stock market environment. With yields at this level, and cash producing a reasonable return, the balanced portfolio will behave more normally.

In addition, that higher cost of capital for companies, reflected in higher interest rates, means that investors in corporate bonds will benefit from greater interest earnings. Those earnings are a cushion against a decline in stock values, should that occur, if stock investors become more concerned about the future of corporate earnings in a slowing economy.

This won’t likely be the last time we see this sentiment shift on the part of bond and stock investors. We are still in a post-pandemic environment where sorting out the future for the economy, corporate earnings and central bank policy are all more complicated because of the aftereffects of pandemic-related policy decisions made by the Fed and the federal government. We remain convinced that the economy will slow, and inflation will continue to decline—but slowly and stubbornly.

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