The Fed Hits the Brakes

Mar 21, 2022

By Ben Norris, CFA, Securities Research Analyst, Associate Vice President

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Markets got back on track last week (following two weeks of negative returns), with stocks recording their best weekly performance since November of 2020. The S&P 500 (SPX) gained 6.2% while the Nasdaq Composite (COMP) gained 8.2% as Technology stocks regained favor with investors. The small-cap focused Russell 2000 index lagged its large-cap counterparts for the week but was still up an impressive 5.4%. The Dow Jones Industrial Average (DJIA) split the difference with a 5.5% gain. Growth-oriented stocks regained favor last week as investors returned to a risk-on posture despite economic and geopolitical headwinds. Illustrating the extent of the risk-on move last week – a Goldman Sachs index tracking stocks in the Technology sector that have yet to turn a profit gained 18%. Many of these stocks have experienced dismal performance over the last few quarters as investors favored higher quality, so this is a particularly notable shift in sentiment.

Consumer Discretionary was the best performing sector last week (+9.3%), followed by Technology (+7.9%) and Financials (+7.2%). On the other hand, stocks in the Real Estate (+2.9%), Utilities (+0.6%), and Energy (-3.6%) sectors lagged the market. Energy stocks have been on a massive run over the last year, gaining nearly 58% on stronger crude oil and natural gas prices. Year-to-date, the Energy sector is still by far the best performer, up 34%. For perspective, the Financials sector is the next best performer and is essentially flat so far in 2022. While we can’t be certain that Energy will continue its impressive run, crude oil and natural gas prices appear primed to remain elevated (thanks to geopolitical tensions and supply constraints) which should in turn lead to solid profitability for these companies.

The headlining piece of news last week was the Federal Open Market Committee (FOMC) decision to raise target interest rates from 0.00-0.25% to 0.25-0.50%, signaling the beginning of a long-awaited normalization campaign for U.S. monetary policy. This is the first time the Fed has raised rates since 2018 and is expected to be the first of seven total 0.25% increases this year. The FOMC did a sufficient job signaling that this hike was coming, and stocks took the news in stride as a result. Yields on U.S. treasuries moved higher following the FOMC’s decision and corresponding commentary that indicated the Fed would begin to decrease its bond holdings relatively soon as well. The tone of the announcement was considered more hawkish (concerned about the impact of low interest rates on inflation) than anticipated.

Recent inflation data has made it hard to argue with a more hawkish stance from the Fed. The Producer Price Index (PPI), which is a measure of selling prices received by domestic producers, increased 10% year-over-year through February and was the highest reading since 2010. Surging prices for food and energy have played a major part in this recent historic rise in PPI and are expecting to feed directly into higher prices for consumers in next week’s Personal Consumption Expenditures (PCE) readout. PCE is the Fed’s preferred measure of inflation and is expected to increase 6.1% vs. last February’s number. Similarly, in the last Consumer Price Index (CPI), inflation increased 7.9% on much higher energy prices.

While the Fed has been watching inflation closely for the last two years, more policy makers are now sounding the alarm that inflation may be a larger and more persistent issue than previously indicated. Critics of the Fed have continued to argue that these recent shifts in policy are too little too late. These critics have history on their side – in the past the Fed has waited too long to take its foot off the gas and has had to slam on the monetary policy brakes. Slamming on the brakes in this case means raising rates and selling assets at a pace that in turn increases the risk of causing a recession. One potential recession indicator that many investors watch is the spread between the yield on two-year and 10-year U.S. treasury notes. In normal times, the yield on a longer maturity bond should be comfortably higher than shorter maturity bonds (the current spread is around 0.20%, down significantly from its 1.60% level a year ago). When shorter maturity bonds yield more than longer maturities, this is referred to as an “inversion” of the yield curve.

The Fed can influence the yield on shorter maturity bonds much more easily than longer bonds with the tools they have at their disposal. As a result, when the Fed chooses to tighten monetary policy, the yield on shorter bonds tends to rise faster than on longer maturities. So, if the yield on the two-year treasury exceeds the 10-year, many interpret this as a failure by the Fed to successfully maneuver a return to “normal” policy. This indicator isn’t fool proof but does have a very good track record of predicting economic slowdowns. Investors will continue to watch this situation closely, and we would expect the calls for a recession in 2022 to get louder if these yields become inverted for a prolonged period.

The bottom line is that the Fed remains in an unenviable position (somewhat of their own making) as they must toe the line between getting inflation under control without causing a full-blown recession.

The upcoming week features an update on inflation in the Consumer Price Index (CPI), consumer sentiment, as well as a variety of employment figures.

Date Report Previous  Consensus
Monday 3/21/2022  Federal Reserve Speakers
Tuesday 3/22/2022 Federal Reserve Speakers
Wednesday 3/23/2022 Federal Reserve Speakers
New Home Sales (seasonally adjusted annual rate)
for February
801,000 820,000
Thursday 3/24/2022  Initial Jobless Claims  214,000 213,000
Continuing Jobless Claims 1.42M  –
Durable Goods Orders  1.6%  -0.5%
 Federal Reserve Speakers
Current Account Deficit (Q4) -$215B  -$220B
Friday 3/25/2022 UMichigan Consumer Sentiment Index 59.7 59.6
UMichigan 5-year Inflation Expectations  3.0%
Pending Home Sales Index (February)  -5.7%  0.0%

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