Closing Out a Busy Summer

What a few weeks we’ve had. Summertime has usually been a quiet time for stock and bond markets but that hasn’t been the case in recent memory. Just this month we’ve had a major shot of volatility, a rapid snapback, and then last week the Fed telegraphed as clearly as it could that it’s time to reduce interest rates. Add those events to all the election cycle news and it’s been a busy summer indeed. Let’s take a few minutes to assess the situation with everything that’s been going on in the markets.

We saw stock prices drop quickly earlier in August. The tide started to turn going into the first weekend and selling accelerated the following week. Ostensibly this was about a disappointing jobs report and Fed policy but what it really seemed like was a lot of trading algorithms taking profits. Whatever the catalyst, it was fast to go down and fast to come back up. According to my research partners at Bespoke Investment Group, the S&P 500 went from “extremely overbought” (compared to its 50-day moving average) to “extremely oversold” in 13 days and then roundtripped that over the next 14 days. That’s one of the fastest bouts of V-shaped volatility in decades. Prices have mostly been higher since so you’d be forgiven if you were on a cruise or something and didn’t know what all the fuss was about. Volatility like that feels horrible at the time but, unfortunately, it’s part of what we have to put up with as long-term investors.

Markets react to a variety of information on any given day but Fed policy/interest rates have been top-of-mind for so many for so long that rate anxiety can occasionally bubble over. That certainly fed into the market volatility just mentioned and, perhaps ironically, also helped markets to recover so fast. This was because as stock prices were falling investors quickly assumed that the Fed would have to lower interest rates soon, and some even said an emergency Fed meeting would be imminent. It’s not the Fed’s job to prop up the stock market but assumptions about a shift in Fed policy got baked in anyway. That, plus other positive economic news helped push prices higher.

Then last week Fed Chair Jerome Powell said in a speech that “the time has come” to start lowering rates. This wasn’t because of market volatility; it was because the inflation situation has improved and higher interest rates have become “restrictive”. Fed Chairpersons usually aren’t that explicit and the rate-setting committee hasn’t yet made a formal decision. However, it seems like this is the shift investors have been waiting for.

Usually the Fed begins an easing cycle by cutting rates by a quarter point, followed by larger reductions over subsequent meetings. As I type investors are pricing in a 70% chance of that quarter point cut while 30% assume a half-percent cut when the Fed meets again in September. This means exactly 0% of the market assumes no cut next month. Further cuts are priced in over following months that would take the Fed Funds rate, the main short-term benchmark that’s relied on so heavily in our financial system, down by maybe 2% from about 5.5% now. Whatever the reduction ultimately is, this should be a tailwind for the economy and, by extension, the stock and bond markets.

Earlier in August when stocks were faltering bond prices were rising. The yield on the benchmark 10yr Treasury note dropped (as bond prices rose) to about 3.8% from over 4%. This yield drives the rate on 30yr mortgages and led to a spike in refinance activity that has settled down a bit sense. Expect those rates to fall further in the months ahead, probably leading to more refinancings which helps more recent homeowners who bought amid higher rates. Lower mortgage rates should also help a national housing market that has been struggling in some areas. And lower rates from the Fed will help borrowers with loans, like credit card balances and equity lines of credit, tied to the PRIME rate. This benchmark is currently at 8.5%, not historically high but certainly high compared to recent history. Any reduction in PRIME will lower borrowing costs for a lot of people, but a 2% reduction perhaps by next Summer would be welcome indeed.

The prospect of lower interest rates has also been giving the bond market a lift. Assuming rates follow something like the expected path, this should continue to buoy bond prices and is a reason to cautiously start putting cash (money market cash and short-term CDs maturing soon) back into medium-term bonds.

Volatility spikes like we saw earlier this month aren’t very common. However, when they have occurred it’s often been in the context of a rising market. Whatever happens in the months ahead, just try to be prepared for the unexpected. Ensure your investment portfolio is set up correctly (my job for many of you reading this) and that your financial house is generally in good order.

So we’ve had some excitement this Summer amid an otherwise positive market and economic environment. Some parts of the stock market had gotten a little ahead of themselves earlier this year and this has levelled out a tad. Inflation is nowhere near the problem it was two years ago and the economy seems to be trucking along. Eventually we’ll see a recession but it doesn’t seem likely anytime soon (I’m literally knocking on wood as I write this…).

One of the bottom lines we should remind ourselves of is that we’re still, even after four-plus years, dealing with issues stemming from the pandemic. Our economy and financial system is large and complicated so it makes sense that historic government intervention back then would take time to work its way through the system. The Fed getting its benchmark short-term rate back to normal (generally agreed to be around 2% lower than current) would be sort of like closing the book on a lingering chapter of Covid’s history.

Have questions? Ask us. We can help.

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