Schwab Market Perspective: Top of the Rate Cycle

April 16, 2023

8 minute read

by Liz Ann Sonders, Jeffey Kleintop, Kathy Jones, and Kevin Gordon, Charles Schwab & Company Ltd.

What does a potential change in Federal Reserve policy mean for markets and the economy?

The Federal Reserve may hike rates again in May, but if so it's likely to be the last rate hike of the cycle. Although the Fed's favorite inflation indicator remains stubbornly high, the risk of a credit crunch and/or a recession has risen, particularly after banking stress appeared in March. This may mean additional volatility for the U.S. stock market; Asian stocks, on the other hand, may continue to offer more relative stability.

Fixed income: Peak of the cycle

We believe that U.S. interest rates are at or near their peak for the current cycle. The Fed may hike the federal funds rate one more time this spring, but we don't expect intermediate- to long-term rates to revisit the levels seen over the past six months.

It looks like the cumulative impact of the Fed's tightening in policy over the past year is working. After raising the federal funds rate at the fastest pace in modern times to cool off an overheating economy, demand growth is slowing and inflation pressures are easing. The latest data from the manufacturing sector have been weak and consumer spending has been softening. Inflation is still well above the Fed's long-term target of 2%, which may mean it opts for another 25-basis-point (0.25%) hike in rates at the Federal Open Market Committee (FOMC) meeting on May 2-3. However, with the risk of a credit crunch and/or recession rising, we see that as likely to be the last rate hike of the cycle.

The yield curve has been signaling for quite some time that rates have peaked and recession risk is rising. The yield spread between two-year and 10-year Treasuries dipped into negative territory more than a year ago. After a temporary rebound, the yield curve has been inverted (meaning long-term yields are lower than short-term yields) for more than nine months. Every recession since 1977 has been preceded by an inverted yield curve. The time frame between a yield curve inversion and recession has varied from as short as six months to as long as 22 months.

An inverted yield curve has preceded every recession since 1977

Chart shows the 2-year versus 10-year Treasury yield spread dating back to 1977, overlaid with gray bars showing the dates of economic recessions. An inverted yield curve preceded each recession, and the curve is inverted now.

Source: Bloomberg, monthly data as of 3/31/2023

Recessions as defined by the National Bureau of Economic Research. Past performance is no guarantee of future results.

An inverted yield curve is a sign that credit conditions are tightening. Because banks tend to borrow in the short-term markets and lend for longer time frames, the Fed's tightening in policy raises the cost of borrowing for consumers and businesses as banks pass along higher costs and/or pull back on lending. These trends are evident in the Fed's recent survey of bank senior loan officers, which indicated that banks are less willing to lend and that demand for loans is slowing.

A rising percentage of loan officers report tighter lending standards

Line chart shows changes in the Senior Loan Officer Opinion Survey on Bank Lending Practices going back to 1993. A rising percentage of loan officers say standards have increased in the past year for loans to large, middle-market and small companies.

Source: Federal Reserve, as of 2/6/2023

Data is from the January 2023 Senior Loan Officer Opinion Survey on Bank Lending Practices

The trend toward tighter credit conditions is likely to become more pronounced in the wake of recent bank failures and the movement of money out of bank deposits and into money market funds. We believe that the Fed will be hesitant to tighten policy much more in light of the heightened risks to the financial system.

U.S. stocks and economy: Getting the inflation story right

There was something for everyone in the March U.S. jobs report (as has been the case for most of the past year). On the upside, the economy added a greater-than-expected 236,000 jobs, the unemployment rate fell to 3.5% from 3.6%, and the labor force participation rate rose to 62.6% from 62.5%. On the downside, permanent job losses increased sharply, and wage growth was likely still too hot in the eyes of the Federal Reserve.

Persistently strong wage growth has been a sticking point for the Fed. The deceleration in average hourly earnings growth this year suggests that the Fed is getting closer to its goal of tamping down inflation pressures. However, much of the slowdown appears to have been driven by the drop in higher-paying sectors' (such as information) payrolls versus those at the lower end of the wage spectrum (e.g., leisure and hospitality).

Higher-paying job loss and lower wages

Chart shows the year-over-year percentage change in U.S. average hourly earnings, as well as payrolls for the leisure and hospitality and information industries. Job growth has decelerated much more in information than in leisure and hospitality.

Source: Charles Schwab, Bloomberg, as of 3/31/2023

Average hourly earnings and nonfarm payroll changes for the "leisure and hospitality" and "information" industries are from the U.S. Bureau of Labor Statistics monthly Employment Situation report. Payroll growth axis truncated for visual purposes.

The strength in hiring (and income growth) lower down the income spectrum is a large part of the reason the Fed has been apprehensive about pulling back on its rate-hiking campaign. Fed officials have been candid about their concern that they may create conditions for a resurgence in inflation—importantly, not just in a metric like the consumer price index, but in the one they focus most on right now: Personal Consumption Expenditures (PCE) Core Services Ex-Housing.

To be sure, there are plenty of signs of disinflation, such as the decline in the "prices" components within the ISM manufacturing and services indexes. Yet, as shown in the chart below, that hasn't materialized into a slowdown in the PCE inflation indicator. The divergence between these series underscores the unique nature of this cycle, as well as the attendant difficulty the Fed will have in adjusting monetary policy.

Inflation metrics have diverged

Chart shows the change in the prices components of the ISM manufacturing and services indices, as well as PCE core services ex-housing, dating back to 1998. Although both of the ISM price indicators have declined over the past year, the PCE index has remained high.

Source: Charles Schwab, Bloomberg. ISM data as of 3/31/2023. PCE data as of 2/28/2023.

The Institute for Supply Management (ISM) manufacturing index, also known as the purchasing managers' index (PMI), is a monthly indicator of U.S. economic activity based on a survey of purchasing managers at more than 300 manufacturing firms; the ISM services index is a similar survey taken among non-manufacturing companies. The PCE core services ex-housing index is released by the U.S. Bureau of Economic analysis as part of the monthly Personal Income and Outlays report. The core index excludes two categories—food and energy—where prices tend to be volatile; core PCE ex-housing additionally excludes house prices and rent.

Even though core inflation has taken longer to decelerate toward the Fed's goal, we think the recent banking stress and tightening in credit conditions will act as a strong disinflationary, if not deflationary, force. While that bodes well for the fight against inflation, it also reflects the risk of overshooting to the downside, as deflation is often consistent with recessions. For that reason alone, investors should be careful what they wish for when it comes to a rapid decline in inflation metrics.

Global stocks and economy: Oasis in Asia

While all major regions posted solid stock market gains during March, it was a volatile month. In contrast, Asia was an oasis of relative calm amid the transatlantic bank stress for a few reasons:

1. No signs of bank stress in Japan. Asia's biggest developed economy has a strong and stable deposit base largely made of households, which implies low "bank run" risk. Despite two decades of zero interest rates, Japan's population still holds more than half of its ¥2,000 trillion of savings in bank deposits. Since the March banking turmoil, there has been no noticeable increase in Japanese interbank funding costs, and Japan's upward-sloping yield curve provides a cushion for banks' net interest margins. Unlike in the U.S. and Europe, there is little pressure on banks to bring deposit rates higher, given that government bond yields remain near zero.

Asia's banks held up better during March bank stress

While the MSCI AC Asia Pacific Financials Index, the MSCI Europe Financials Index and the S&P 500 Financials Index all fell into negative territory during March, the Asia Pacific Index did not decline as much as the other two.

Source: Charles Schwab, Bloomberg data as of 4/1/2023

The MSCI AC Asia Pacific Financials Index includes large and mid-cap securities across five developed-market countries and nine emerging-market countries in the Asia Pacific region. All securities in the index are classified in the Financials sector as per the Global Industry Classification Standard (GICS^®). The MSCI Europe Financials Index captures large and mid-cap representation across 15 countries in Europe; again, all securities are classified in the Financials sector as per GICS. The S&P 500^® Financials Index measures the performance of those companies included in the S&P 500 that are classified as members of the GICS Financials sector. Past performance is no guarantee of future results.

2. Fewer Fed rate hikes a positive. Bank stress in the U.S. leading to tighter lending standards may substantially reduce the outlook for additional rate hikes by the Fed, with tighter conditions substituting for tighter monetary policy to restrain growth and inflation. This is a net positive policy shift from the standpoint of most Asian economies. Fed monetary policy tightening has spillovers to Asia, historically resulting in higher financial volatility, capital outflows and currency depreciation, with many central banks in Asia responding by raising rates, which could slow the region's economic growth. In contrast, the substituted impact of tighter bank lending standards are more U.S.-centric, with fewer channels of spillover to Asia.

3. Strengthening growth. Domestic demand is surging in China, supporting growth across Asia. First quarter gross domestic product (GDP) estimates for China continue to rise, as you can see in the chart of economists' consensus forecasts below.

China's first quarter GDP outlook has sharply improved

Chart shows the consensus economist forecast, as tracked by Bloomberg, for China's first quarter 2023 gross domestic product growth. The forecast has risen in recent months and is currently above 1.75%.

Source: Charles Schwab, Bloomberg data as of 4/3/2023

Q1 GDP estimate not annualized.

The relative calm in Asia's markets could become more turbulent. Persistent inflation in Japan is driving higher-than-expected wage increases, which may require the Bank of Japan to pivot away from yield-curve control and zero-interest-rate policies. Korea's rate hikes have managed to slow the pace of inflation, but may weigh on domestic demand, including housing. We are still seeing elevated inflation in places like India and the Philippines. Efforts in Vietnam to slow inflation have already dampened domestic growth, with the central bank cutting rates last month. It's also worth noting that geopolitical risk is ever present when investing internationally.

What investors can consider now

Given the situation outlined above, we expect Asian stocks may continue to offer lower volatility than U.S. and European counterparts.

In the U.S., the elevated uncertainty stemming from bank strains and the expected pullback in activity has led investors to flock to higher-quality, large-capitalization stocks. The average gain for the five largest names in the S&P 500 nearly reached 15% in March, while the average gain for the rest of the index was slightly negative.

Large-cap stocks led the pack in March

Chart shows the performance of the five largest stocks in the S&P 500 by market capitalization versus the remaining 495 stocks for each month dating back to January 2022. Gains for the 5 largest stocks were nearly 15% in March, while the average gain for the rest of the index was slightly negative.

Source: Charles Schwab, Bloomberg, as of 4/7/2023

"Top 5" represents the five largest stocks in the index by market capitalization in any given month. "Other 495" represents the rest of the index not included in the top five. Past performance is no guarantee of future results.

That dynamic may persist, as smaller companies tend to bear the brunt of the pain from a potential recession, but we'd be wary of any rally that has thin participation among members. Investors should look for stronger breadth to confirm a sustainable move higher.

Aside from focusing on higher-quality stocks, such as those from well-established companies with a history of dependable earnings, we continue to favor "short-duration" stocks, those with more immediate cash flows. Over the past 12 months, short-duration stocks have outpaced the overall market and acted as a hedge against the losses in the overall market by holding their value, although they did not outperform in March. It's possible that short-duration stocks have started to underperform now that central banks appear close to the end of their rate-hike cycles, but we don't think so.

For fixed income investors, we believe signals point to the likelihood that intermediate- to long-term yields will continue to trend lower, while their prices will trend higher. In past cycles, as the federal funds rate peaked, intermediate-term bonds' total return tended to outperform that of short-term bonds during the subsequent 12 months. Consequently, we continue to suggest that investors add duration to bond portfolios.

Intermediate-term bonds have outperformed short-term bonds at the end of the rate-hike cycle

Bar chart shows 12-month total return for short-term and intermediate-term bonds around the peak of the federal funds rate in December 2018, June 2006, May 2000, March 1997, February 1995 and February 1989. Intermediate-term bonds had higher total returns in each instance.

Source: Ibbotson, as of 12/30/2022

Twelve-month total returns for each period begin three months prior to the peak in the federal funds rate. Short-term bonds are represented by the Ibbotson U.S. Short-Term Government Bond Index and intermediate-term bonds are represented by the Ibbotson U.S. Intermediate-Term Government Bond Index. Past performance is no guarantee of future results.

Kevin Gordon, Senior Investment Strategist, contributed to this report.