Friday Reflection | May 5, 2022
When making a change, the pace impacts the experience. If you start early, you can afford to make slow and steady progress, even when pursuing large changes. When you delay and wait until the problem is on your doorstep, you rarely have the luxury of a slow and steady pace – instead, disruptive change becomes necessary, and the experience shifts to one of frenzy and heightened uncertainty.
In the wake of the pandemic, the Fed waited as long as it could before raising interest rates above zero, doggedly sticking to a narrative of “transitory” inflation and accommodative policy. Instead, inflation has proven persistent, leaving the Fed with a shorter timeline and a pace of rate hikes that has made investors uncomfortable.
Against this backdrop of an aggressive interest rate trajectory, both stock and bond markets have experienced material declines to start the year. From January through the end of April, the S&P 500 index dropped by -13.3%, marking the worst four-month opening to the year since 1939. Investment grade bonds have declined by -9.4% through the end of April. This marks the fifth consecutive month of negative returns, the longest such streak since 1994, and at an even steeper trajectory. While normalizing interest rates is ultimately a healthy thing for markets, the current pace of change has disoriented investors and put downward pressure on prices – and the volatility may not subside in the short-term.
Threading the Needle
The Federal Open Market Committee (FOMC) voted unanimously on Wednesday to increase its benchmark interest rate by 0.50%. Investors expected this highly telegraphed move, but many remain skeptical about the Fed’s ability to engineer a ‘soft-landing’ for the domestic economy. The Fed is effectively using higher interest rates to slow down the economy and dampen price inflation while attempting to thread the needle of not slowing so much that the economy slips into a recession.
The sharp upward trend in inflation, including the spike in energy prices following the Russian invasion of Ukraine, has required a stronger than normal policy response. This marked only the second time since 2000 that the Fed increased rates by a half-point at a single meeting, and markets have priced in additional half-point hikes at both of the FOMC’s June and July meetings. 1994 was the last time that the Fed hiked rates by a half-point or more multiple times in a single year. The central bank raised its target rate by 3.0% over seven meetings. Before then, half-point or greater increases were most commonly seen in the early-1980s, when the Fed was battling high inflation – a familiar foe in the current environment.
Officials also decided to begin shrinking the Fed’s $8.9 trillion balance sheet starting June 1, at a monthly pace of $30 billion in Treasuries and $17.5 billion in mortgage-backed securities, stepping up over three months to $60 billion and $35 billion, respectively. The balance sheet ballooned in size when the Fed aggressively bought securities to soothe financial markets and keep borrowing costs low as the pandemic spread – and now their shift from being a large buyer to a large seller adds to downward pressure on prices.
A growing number of critics are saying the central bank waited too long to stamp out inflation without causing a recession. Fed Chair Powell admitted to Congress in early March: “Hindsight says we should have moved earlier.” While the Fed can argue that everything changed when Russia invaded Ukraine and oil prices doubled, the reality is that inflation had already taken hold in Q4 of last year and the Fed wasn’t quick enough to evolve from their inflation-is-transitory viewpoint.
Some investors are concerned that given the late start, an even faster pace is necessary. When asked on Wednesday whether future hikes could be larger than 50 basis points, Powell was clear: “A 75 basis point increase is not something the committee is actively considering.” Markets reacted favorably in the immediate aftermath of those comments, rallying more than 3% on Wednesday, but Thursday saw stocks give back all those gains and more. After the initial euphoria, investors realized that the main message from the Fed is this: they are committed to raising rates and taming inflation irrespective of short-term consequences for investment markets.
Bonds are Misbehaving
While falling bond prices are logical in the context of rapidly rising interest rates, the experience for investors can be uncomfortable. This is especially unsettling for those in cautious portfolios with a heavy allocation to bonds that are not used to price swings. Bonds traditionally act as a stabilizing force in a diversified portfolio, and a buffer for those who want a more careful investment approach.
Mortgage rates in the US resumed their upward climb as a direct result of the rate increase, reaching the highest level since August 2009. The average for a 30-year loan reached 5.3% last week, representing a significant increase from the 2.9% average rate one year ago. This means that the cost of a $500,000, 30-year mortgage is almost $700 a month higher compared to this time last year. Mortgage originations are slowing as a result. While homebuyers may be disappointed about higher mortgage costs, the policy is working in terms of slowing down certain parts of the economy to moderate inflation.
We have lived in this ultra-low interest rate environment for so long that many people have forgotten that higher rates are normal. When we take a historical view, a 5% mortgage is still relatively cheap. Rates on savings accounts and CDs will increase as well, which will be welcomed by savers who have tolerated zero percent rates for the past decade. This normalization is a healthy step for the economy longer-term and for investors who want options for cautious return; going forward bond investors will benefit from higher yields. Nonetheless, we expect that weaning the economy from low rates will mean that price volatility stays with us in the near-term.
Markets Will Recover
Market volatility is, in fact, normal. Over the past 70 years, the S&P 500 has averaged an intra-year decline of at least -15% every 3.3 years. For investors who understand this and have proper liquidity and the ability to remain invested, the growth has been significant, even if the pace of change was uncomfortable at various moments along the way.
In the current market, the Fed is in the unenviable position of accelerating the pace of change. The bottom line is that they should have started earlier. They are now taking the right steps, but they don’t have the luxury of a slow and steady approach. That means that the bumpy start to the year may continue until we reach a new plateau of stability.
No one enjoys losing money, which can lead to the desire to take some form of dramatic action in a landscape of negative returns. Yet, history provides repeated lessons that all offer the same conclusion: remaining invested through difficult patches in the market is the surest way to grow your wealth and financial resiliency over time. This is as true with bond markets or real estate markets as with stock markets, although all three are not usually down significantly at the same time. At North Berkeley, we continue to rebalance portfolios regularly through the volatility, taking advantage of lower prices and tax opportunities as they present themselves. While price volatility is stressful in the short-term, it is in these periods of market turbulence that investors can plant the seeds of long-term growth.
 Fed Lifts Interest Rates by Half Point in Biggest Hike Since 2000. WSJ
 Transcript of Chair Powell’s Press Conference, May 4, 2022. FederalReserve.gov
 Primary Mortgage Market Survey®. US weekly averages as of 05/05/2022. Freddie Mac
 Intrayear declines in the S&P 500 have averaged -13.7% since 1952, yet annual price returns have been positive in 51 of those 70 calendar years. Capital Group / American Funds
About Brian Kozel, CFP®
Brian Kozel is a Partner at North Berkeley Wealth Management. Brian helps clients feel confident as they navigate their financial journey.
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