Wall Street’s dream scenario is dead

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Wall Street’s vision of a Goldilocks scenario for the stock market and economy is unraveling.The Fed’s “higher for longer” mantra has dashed hopes that a recession is avoidable.The US economy is feeling the lagging effects of tight monetary policy as risk factors converge.

Wall Street’s dream of a Goldilocks scenario for the stock market and economy is probably dead. 

At best, it’s severely wounded. 

And all it took was a single press conference in September from Fed Chair Jerome Powell to dash hopes that had been building on Wall Street all year. 

What happened?

Interest rates soared. That’s what happened.

It’s already been tough for investors to watch the 10-year US Treasury yield surge from 1.1% in January 2021 to 4.84% today — but the key bond yield has now spiked a full percentage point over the past 10 weeks alone. 

That’s a huge move, and the relentless drive higher in interest rates has been sparked by Powell’s insistence that another rate hike is likely necessary to quell inflation. 

Powell spoke and investors finally listened. The Fed signaled that it expects to keep its benchmark Fed Funds rate above 5% well into 2024, running counter to the investors’ previous expectation of interest rate cuts as early as the first quarter of next year. 

The reaction in the stock and bond markets has been swift and violent. The 10-Year US Treasury yield surged to 4.84%, while the S&P 500 extended its drawdown from the end of July to nearly 10%. 

With interest rates exceeding levels not seen since 2007, investors and consumers are growing more concerned that something in the economy is about to break.

What changed?

After shrugging off rate hikes and threats of higher for longer for most of this year, the market decided that the September policy meeting was the inflection point and began to take the Fed at its word: higher rates are here to stay. Buckle up. 

Investors are growing increasingly concerned that the Fed’s persistently hawkish monetary policy, even after inflation dropped from its 9% peak in June 2022 to 3% in July, is bound to break something in the economy.

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We already got a taste of that when interest rates soared earlier this year, sparking massive bond losses at regional banks that led to the implosion of Silicon Valley Bank. At that time, the 10-year US Treasury yield was below 4%. Today, it’s closer to 5%.

So what’s next to break? Bond portfolios, potentially. 

Investors and banks are sitting on massive losses on their bond holdings that rival a full blown stock market crash, with bonds with maturities of 10 years or more down a whopping 46%, on par with the dot-com bubble burst in 2000. 

The consumer, meanwhile, is getting pushed to the limit.

Credit card debt has surged above $1 trillion, delinquency rates for auto loans and credit card loans are on the rise, student loan payments are resuming this month for the first time in three years, and near 8% mortgage rates have made the prospect of buying a home prohibitively expensive for millennials. 

“Consumers are becoming more conservative with their spending as they continue to face a trifecta of headwinds including elevated inflation, higher interest rates and slowing labor market and income gains. The restart of student loan payments on Oct. 1, the near depletion of excess savings, and tight credit conditions will further weigh on consumers’ ability to spend going into next year,” EY’s chief economist Greg Daco said last month. 

Something’s got to give, and it all goes back to the Fed.

Goodbye, soft landing? 

Company CEOs, economists, and investment strategists have been warning since 2022 that a recession hitting the US economy is a question of when, not if. 

And then consumers surprised everybody. As painful as inflation and higher interest rates were, the economy remained resilient as consumers held onto their jobs and kept swiping their credit cards. The latest jobs report shows employers added a stunning 336,000 jobs in September alone. 

Productivity gains from artificial intelligence, decelerating inflation, falling oil prices, and a weakening US dollar meant that calls for a soft landing grew louder and louder, helping the S&P 500 surge as much as 32% from its bear market low.  

But in just a few short weeks, it appears that the Fed has wiped out Wall Street’s mirage of a soft landing with just three words: higher for longer. 

And there’s real reason to be concerned that the economy is in a more fragile state than any single data point may suggest, and it really all goes back to this rapid rise in interest rates, which is throttling consumers and businesses alike. 

“We have a crisis emerging. If you’re [a company] in the S&P 500, you have no trouble financing your business. You can’t say that about small business anymore. The cost of capital has gone through the roof,” Shark Tank’s Kevin O’Leary said last month. The surging cost of capital is why bankruptcies in America are starting to pile up.

This week, Bloomberg economists said that a recession was likely to strike as early as the last months of this year and it could be officially called in the early days of 2024. 

What happens next?

The path for the economy to stick a soft landing has narrowed. For the Goldilocks scenario to emerge, the Fed needs to look in the mirror and acknowledge all of the progress it has made taming inflation over the past two years, even as the jobs market remains strong.

It has to acknowledge that interest rates are now sufficiently restrictive, and decide that it’s next monetary policy move isn’t an interest rate hike, but rather a pause, and then a cut. 

“There should be no question now that the Fed should be done. I mean, we’ve had almost 50 basis points of tightening on the long end since the last meeting,” Wharton professor Jeremy Siegel told CNBC on Thursday, adding that uncertainties surrounding labor strikes and a potential government shutdown should push the Fed to stop hiking rates.

Some Fed members are beginning to acknowledge this, with recent comments from Fed Presidents Mary Daly and Raphael Bostic suggesting that the recent surge in interest rates is doing the Fed’s job in tightening financial conditions.

The future of stocks will continue to be defined by how rigorously the Fed sticks to its higher-for-longer plan, and when it starts to signal that rate cuts could be coming. Investors could be in for a lengthy wait, and the mega-cap tech corporations fueling so much of the market’s prosperity will keep feeling the pressure of high rates on their future earnings. It’s a potential recipe for disaster for a market already tenuously dependent on such a small group of names.

If inflation continues to fall — which seems likely as lagging shelter prices used in the Fed’s inflation calculation start to reflect that rents have been dropping over the past year, and if the unemployment rate stays at historically low levels — then it’s mission accomplished for the Fed.

But if the Fed continues to push the brakes too hard on the economy, moving forward with more interest rate hikes, then investors can say goodbye to a soft landing scenario and hello to a recession.

Read the original article on Business Insider

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