December 2022

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The Federal Reserve’s Open Market Committee (“FOMC”) meets next on February 1, 2023. At that meeting, the market anticipates the penultimate rate hike for this cycle. Additional data should confirm inflation is decelerating. At some point in 2023, perhaps as early as the March FOMC meeting, the Fed could conclude its most aggressive tightening cycle since the early 1980s, a welcome development for financial markets. By the time of our Symposium, therefore, there should be clarity with respect to the Fed’s policy stance.

Last year represented the worst year for a balanced portfolio of stocks and bonds since 2008. It was also the worst year for bond markets since the 1930s. In 2022, the Fed substantially increased the cost of capital, and higher discount rates reduced valuations of all assets. For most of 2022, the stock market, in particular, was excessively focused on the Fed’s endpoint, known as Terminal Fed Funds. Short-term tactical strategies feared “missing the bottom” of the market. As long-term investment managers, we are less concerned with market timing and more interested in the fundamental impact of monetary policy regimes.

The bond market is convinced the Fed has already tightened monetary conditions too much. The inverted Treasury yield curve is one indicator that confirms the outlook. Certain predictive models argue recession is inevitable. Those models further predict the Fed will cut rates in late 2023 or early 2024. We disagree and believe, instead, that the Fed has other considerations.

At its peak in 2020, there was $18.4 trillion in global sovereign debt with a negative yield. Today, there is only $254 billion, with the entire balance in Japan. NIRP, or Negative Interest Rate Policy, was the epitome of an extraordinary monetary policy response to the Great Financial Crisis and the COVID pandemic. In the US, rates never reached negative values, but policy and market rates remained near zero for more than a decade. During that era of “financial repression”, borrowers benefited at the expense of savers. Asset market valuations expanded exponentially, and the “wealth effect” supported consumption.

The Fed’s aggressive posture toward inflation in 2022 effectively ended the Era of Financial Repression and launched a new Era of Policy Normalization. We believe the Fed’s objectives include more than controlling inflation. In our view, the Fed will maintain tight conditions until it has substantially reduced the size of its balance sheet. This will be accomplished through Quantitative Tightening, a form of liquidity withdrawal from the markets.

We acknowledge numerous indicators suggest economic growth is decelerating. However, we are not yet prepared to concede that recession is imminent. Unemployment is quite low, and the consumer is in much better financial shape than during previous tightening cycles. Nevertheless, the first 2 – 3 quarters of 2023 should provide insight and could ultimately settle the debate. With each economic release, uncertainty will diminish, but we also anticipate heightened market volatility.

Fortunately, policy normalization has resulted in the most attractive Treasury yields since 2007. The dynamic has reversed – i.e., savers now benefit at the expense of borrowers – a welcome development for many of our clients. There are now attractive alternatives for investors who need income. We look forward to discussing these issues with you in the New Year. Please contact the office if you would like to schedule a virtual or in person meeting.