The Fed Did It – Week in Review

The Fed Did It

The Fed did it and raised interest rates in March 2022 for the first time since 2018. Investors expected this action. However, this change and the hawkish statements from the Fed and Chairman Jerome Powell have implications from investors.

The US Federal Reserve voted to approve a 0.25% increase to the federal funds rate. Specifically, the Federal Open Market Committee (FOMC) directed the Open Market Desk at the Federal Reserve Bank of New York to,

Undertake open market operations as necessary to maintain the federal funds rate in a target range of 1/4 to 1/2 percent.

The Fed also had five other items in the directive related to its US Treasury and Mortgage-Backed Securities (MBS) holdings. First, the Fed has completed its tapering operations, meaning it is no longer adding to the balance sheet. Instead, the Fed is rolling over and reinvesting all principal payments.

Indicators of economic activity and employment have continued to strengthen. Job gains have been strong in recent months, and the unemployment rate has declined substantially. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.

The invasion of Ukraine by Russia is causing tremendous human and economic hardship. The implications for the US economy are highly uncertain, but in the near term, the invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity.

The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. With appropriate firming in the stance of monetary policy, the Committee expects inflation to return to its 2 percent objective and the labor market to remain strong.

The bottom line is the Fed views inflation as high, it may get higher, and they are going to change monetary policy to bring inflation back to 2%.

Why Did the Fed Increase Interest Rates?

The US Federal Reserve is increasing interest rates because of inflation. The Fed has a dual mandate: maximum employment and low and stable inflation. Unemployment has been near a record low in the past 20-years at 3.8%. Furthermore, jobless claims are at just 187,000, the lowest since 1969.

On the other hand, inflation is rising in 2022 and at 7.9%, is at a 40-year high. Moreover, the inflation rate was even higher in some regions of the US due to drought and labor shortages. However, this is not unique to the US; inflation is high in other countries worldwide. For instance, Canada’s inflation rate is at a 30-year high.

Inflation has proven to be stubbornly high as the impact of the COVID-19 pandemic, supply chain issues, and now the war in Ukraine disrupt global trade and economies.

Since unemployment is low and inflation is high, the Fed did it and increased interest rates.

What Happens When the Fed Raises Interest Rates?

Investors are likely worried about what happens when the US Federal Reserve raises interest rates. The bottom line is that the cost of borrowing money increases. The Federal Funds target rate does not directly impact consumers and businesses. However, it does directly impact banks. Banks borrow overnight loans from the Fed to meet liquidity requirements. 

Borrowing is More Expensive

Since banks are now borrowing money at a higher rate, they will loan money out at a higher rate. The rule of thumb since 1994 for the prime rate is the Federal Funds target rate + 3.5%. The prime rate impacts auto loans, mortgage rates, credit cards, etc. Loans that had interest rates of 3.75% are now about 4%.

Savings Accounts Earn More

On the flip side, higher interest rates are good for savers. Short-term investments like high yield savings accounts, certificates of deposit (CDs), and money market deposit accounts (MMDAs) will have incrementally higher interest rates. Series I Savings Bonds also will earn higher rates.

Impact on Stocks

Stocks tend to decline in anticipation of higher interest rates; this is especially true of tech stocks. The Fed started tapering in October 2021 and signaling potential rate hikes in 2022. Tech stock prices plunged in response.

Markets are anticipating costs will rise for businesses since loans are more expensive.

Bonds are Punished

Bonds are severely punished in a rising interest rate environment. The interest rates on bonds are inversely related to bond prices. If interest rates rise, bond prices decline, and vice versa. Current bonds pay a lower interest rate than newer bonds, and thus their price must drop to pay a higher interest rate.

According to StockRover*, long-term US Treasuries and corporate bonds have the worst performance of all asset classes.

Final Thoughts on The Fed Did It

Investors should be aware that the Fed is bringing its tools to bear to reduce inflation. First, the US Federal Reserve has completed tapering and is no longer buying bonds. Then, after much anticipation, the Fed went ahead and did it and increased interest rates for the first time since 2018, and another hike is likely to be implemented in the next FOMC meeting. Next, the Fed is going to reduce its balance sheet.

This change will probably cause volatility in the stock and bond markets. So, investors should be prepared for a bumpy ride.

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The Stock of the Week

Today I highlight Stanley Black & Decker (SWK). The company traces its history to 1843, and today, it is the market leader in producing hand and power tools for the US market. Stanley operates in three business segments: Tools and Storage, Security, and Industrials. The stock price has plunged (-26.3%) YTD on a revenue miss, lower margins, and rising interest rates. However, Stanley is a Dividend King and Dividend Aristocrat with 54 years of consecutive increases. The forward yield is now ~2.3%, higher than the 5-year average of 1.77%. The stock has been trading below its P/E ratio range for the past decade, but the risk is earnings may fall farther than expected. Investors should keep an eye on this stock now.

The screenshot below is from Stock Rover*.

Dividend Increases and Reinstatements

Search for a stock in the list of dividend increases and reinstatements. This list is updated weekly. In addition, you can search for your stocks by company name, ticker, and date.

Dividend Cuts and Suspensions List

The dividend cuts and suspensions list was most recently updated at the end of January 2022. As a result, the number of companies on the list has risen to 543. Thus, well over 10% of companies that pay dividends have cut or suspended them since the start of the COVID-19 pandemic. The list is updated monthly.

One new addition indicated that companies are experiencing solid profits and cash flow in January.

The new addition was Compass Diversified (CODI).

Market Indices

03/26/22

Dow Jones Industrial Averages (DJIA): 34,861 (+0.31%)

NASDAQ: 14,169 (+1.98%%)

S&P 500: 4,543 (+1.79%)

Market Valuation

The S&P 500 is trading at a price-to-earnings ratio of 25.91X, and the Schiller P/E Ratio is about 36.81X. Note that the long-term means of these two ratios are 16.0X and 16.9X, respectively. 

The market is still overvalued despite the recent market correction and rebound. Earnings multiples more than 30X are overvalued based on historical data.

S&P 500 PE Ratio History

Shiller PE Ratio History

Stock Market Volatility – CBOE VIX

This past week, the CBOE VIX measuring volatility was down about three points to 20.81. The long-term average is approximately 19 to 20. The CBOE VIX measures the stock market’s expectation of volatility based on S&P 500 index options. It is commonly referred to as the fear index.

Yield Curve

The two yield curves shown here are the 10-year US Treasury Bond minus the 3-month US Treasury Bill from the NY York Fed and the 10-year US Treasury Bond minus the 2-year US Treasury Bond from the St. Louis Fed.

Inversion of the yield curve has been increasingly viewed as a leading indicator of recessions about two to six quarters ahead, according to the NY Fed. The higher the spread between the two interest rates, the higher the probability of a recession.

Economic News

Federal Reserve Chairman Jerome Powell speaking at the National Association for Business Economics (NABE) Annual Economic Policy Conference, emphasized that there is an “obvious need” to return monetary policy to a “more neutral level quickly” and to move to more “restrictive levels” if required to restore price stability. The Fed chair characterized the labor market as “very strong” and inflation as “much too high.”

The US Census Bureau reported that sales of newly built homes fell 2.0% in February from a downwardly revised January rate of 788,000. The February seasonally adjusted annual rate of 772,000 is down 6.2% from a year earlier and represents the second straight monthly decline. Regionally new home sales increased in the Northeast (+59.3%) and Midwest (+6.3%), while sales decreased in the West (-13.0%) and South (-1.7%). The average sales price for a new home sold in February was $511,000, while the median price was $400,600, a 10.7% increase from a year ago.

The US Census Bureau reported that new orders for durable goods decreased 2.2% to a seasonally adjusted $271.5 billion in February. The decrease follows four consecutive monthly increases; January reported a 1.6% increase. Total durable goods orders are up 14.2% year over year. Much of the decline in the headline number is attributable to a 5.6% drop in transportation equipment, with orders for non-defense aircraft and parts down 30.4%. Automobile makers also reported a 0.5% drop in new orders.

Thanks for reading The Fed Did It – Week in Review!

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