The Fed Makes a Hawkish Pivot

by Jurrien Timmer, Director of Global Macro, Fidelity Investments

Key takeaways

  • Although the 0.25 percentage point hike last week was widely anticipated, the Fed's so-called "dot plot" showed its members may have adopted a more hawkish stance.
  • Whether we could see more such hawkish pivots ahead may depend on the trajectory inflation takes.
  • One positive development for stocks is that consensus earnings estimates for 2022 have actually been increasing.
  • If inflation remains high over the long term, there could be advantages to modifying the traditional 60% stocks, 40% bonds model.

The long-awaited March Federal Open Market Committee meeting finally happened last week, and revealed that the Fed has had to pivot yet again.

While the 0.25 percentage point hike was widely expected, the big news came in the Fed's revised dot plot. The dot plot shows each individual committee member's personal assessment of appropriate monetary policy for coming years and the long run (via a chart of anonymous dots). The last time the plot was released, in mid-December, it showed that a majority of members felt the federal funds rate could remain below 1% through 2022 and below 2% through 2023.

But the plot released last week showed a substantial shift, with a majority of members anticipating rates would need to rise above 1.5% by year end, and suggesting that the Fed will end this cycle closer to 3% than the previously expected 2%. This was yet another hawkish pivot. The forward yield curve is now pricing in a terminal rate for this hiking cycle of 2.75% in 2023, followed by a 0.5 percentage-point decline by 2025.

Judging by the move in real rates (meaning interest rates minus inflation) following the announcement, my guess is that the Fed may have found some vindication in its hawkish pivot. The Fed must have been frustrated that after all its guidance since December (which resulted in a significant tightening of real rates), all this progress was undone in just a few weeks following Russia's invasion of Ukraine. But last week real rates rose again, putting the Fed back on track in its goal of taking some steam out of the economy.

More pivots ahead?

The risk is that the Fed will need to pivot again in the coming months, dragging rates yet higher and potentially triggering a yield curve inversion (this is when long-term rates fall below short-term rates, and is often seen as an omen of recession).

Time will tell, and a lot will depend on what happens to inflation between now and 2023. The more stubborn inflation remains, the further below zero real interest rates fall, and therefore the more the Fed will then need to tighten. So far, inflation expectations are only getting worse (as shown below by breakeven inflation rates implied by yields on Treasury Inflation-Protected Securities, or TIPS).

Yet, while the Fed remains accommodative in real terms, there are already signs that its tightening guidance is working. The 30-year mortgage rate jumped above 4.15% last week, well above the average rate on outstanding mortgages of 3.37%. And the 10-year Treasury yield reached a new 3-year high of 2.24% last week.

Stock market outlook

After a bumpy start to the year, the S&P 500Ā® entered correction territory in February. So far, the intraday low for the S&P 500 remains 4,115, which it hit on February 24, the day that Russia invaded Ukraine. Although we have had several retests since then, thus far that low has held for the S&P 500.

Where could the market go from here? I still see some potential downside risk based on, as I have written about in the past, my analysis that price-earnings (P/E) ratios became artificially inflated in recent years and will need to decrease. However, P/Es could decrease with no further market decline if earnings growth can provide an offset. So far, the consensus earnings estimate is actually moving higher. This is a good sign and suggests that we could have a further decrease in valuations without knocking down stock prices.

And with this year's correction, the S&P 500's valuation has gotten somewhat more appealing. The P/E ratio is down 20%ā€“25% from the highs, and the free cash flow yield is now up to 4.3%.

Looking for an all-weather asset allocation

The recent pullback has also provided a stark reminder that the traditional 60% stocks, 40% bonds model has historically worked best during low-inflation periods. That's because in times of low inflation, bonds have historically been negatively, or inversely, correlated to stocks (meaning that when stocks fall in price, bonds rise). But during high-inflation periods, bonds tend to become positively correlated to stocksā€”reducing their diversification benefits. With inflation rapidly rising in recent months, we are already starting to see the correlation between stocks and long-term bonds become much less negative than it used to be.

So what could one do about this? What if we are entering a long-term period of higher inflation, and traditional bonds offer neither compelling yields nor negative correlations? Could there be a better mousetrap out there? Could we replace the traditional 60/40 with a more inflation-resistant 60/40?

There are a number of ways this might be accomplished, but here is one potential hypothetical solution. Suppose that on the stock side, I don't want to give up on the big growers, but I do want to get some inflation protection from value and small caps. Perhaps I could replace the 60% S&P 500 allocation with 30% large-cap growth and 30% small-cap valueā€”in other words, a style-box barbell.

On the bond side, suppose I replaced the 40% allocation to investment-grade bonds with a mix of 10% TIPS, 5% long-term bonds, 5% high-yield bonds, 10% gold, 5% cash, and 5% commodities.

How might this hypothetical inflation-resistant allocation have performed historically? The chart below shows the results in terms of total return. I was surprised to see how close the inflation-resistant 60/40 came to the long-term performance of the S&P 500, and how much better it could have performed than the traditional 60/40.

On other measures, the inflation-resistant 60/40 portfolio shows some potential advantages. It compares well to the traditional 60/40 model in terms of risk-adjusted returns (which measures returns divided by volatility). Historically, this mix could have generated more return for only slightly more volatility than the traditional 60/40 model, and could have provided an inflation hedge that didn't cost too much during disinflationary periods.

As always, investors should consider their goals, risk tolerance, and other factors in determining their asset allocation, and long-term portfolio adjustments are not to be taken lightly. But perhaps for some investors, this could be a model of an all-weather asset allocation for an uncertain future.

 

About the expert

Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.

 

 

 

Copyright Ā© Fidelity Investments

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