Markets Realize Rates Will Be Higher for Longer

Investors finally are accepting that the Federal Reserve is in a “forever war” against inflation.

Beginning in early 2022, investors ignored strength in the economy and labor market and convinced themselves the Fed soon would bring interest rates back near zero.

The furious stock and bond rally of November and December brought the yield on the 10-year treasury bond down to 3.79% from almost 5% in mid-October.

At the start of 2024, futures markets prices indicated that investors expected the Fed to reduce interest rates about twice as much during the year as the Fed itself anticipated.

But economic data forced investors to recognize reality, and market interest rates recently reversed course. The 10-year yield recently moved back above 4.4%. The long-term treasury bond ETF (TLT) fell more than 6% to start the year.

It’s too risky for the Fed to reduce interest rates while the economy is growing and wages are rising faster than inflation. Doing so could cause inflation to surge again before it even fell close to the Fed’s 2% target.

After easing too much in 2020 and 2021, the Fed is not going to risk reversing the progress it made reducing inflation in 2022 and 2023.

Investors are recognizing this, which is why market rates bounced higher to start 2024.

That’s bad news for bonds but good news for stocks.

Many investors and analysts anticipated a recession would occur sometime in 2022 and 2023. That dampened the prices of most stocks.

But solid economic growth and a strong labor market make it likely consumers will keep spending and corporate profits will continue to increase.

Also, the Fed hasn’t maintained the tight monetary policy of 2022. Though its held rates steady, the Fed increased the monetary base, injecting more money into the economy. That supports economic growth.

Most of the stock market’s 2023 gains were concentrated in a few stocks dubbed the Magnificent Seven.

Those stocks now are highly valued, and their prices depend on sustained high earnings growth. The rest of the market is moderately priced and lagged well behind the indexes the last couple of years. I think more stocks will see solid gains in 2024.

We’ve already seen a turn in the market leaders. The year started with weakness in Apple (AAPL), Tesla (TSLA) and Alphabet (GOOG), reducing the Magnificent Seven to the Fantastic Four.

At the same time, small company stocks gained more than the major indexes. It’s still too early to be sure there’s a lasting change in the market leadership, but I think it’s developing.

Higher stock prices and lower bond prices are likely for the rest of the year.

It’s still important that our investments have solid margins of safety and our portfolios be diversified and balanced.

Speculative investors can move the markets irrationally, as they did the last few years.

We also want to avoid stocks that have extended prices because of high valuations and expectations that historic profit margins will continue. It’s not clear their margins can remain at these levels. If they don’t, valuations and prices should fall.

Geopolitics are a higher potential source of market vulnerability than they’ve been in decades. Markets had modest reactions to the invasion of Ukraine, the Israel-Hamas war and other events. That could change in future conflicts.

Despite the pockets of opportunity, there’s still risk in stocks and other investments. Remember that cash outperformed the stock indexes the last two years and still is attractive at current yields.