April 19, 2022
The Fed Has Been Busy
The Federal Reserve has significantly altered their guidance in the last few months. The biggest change is the increase in the expected number of rate hikes this year. In December, the Fed was expecting three rate hikes in 2022. Three weeks ago, they increased that forecast to 7, and the market is now expecting 8. In 2022, that means short-term interest rates could increase from 0.12% to 2.12%.
The Federal Reserve has a “dual mandate.” The two things they are focused on are keeping the population at full employment and keeping inflation in check. Economists generally view full employment as an unemployment rate of 5% or lower and the Fed targets long-term inflation as 2%.
The rate hikes are expected to be modestly harmful to asset prices and represent action meant to cool an economy that is overheating. There is good reason for this; in March, the unemployment rate dropped to 3.6%. At the same time, the Federal Reserve is expecting inflation of 4.3% for 2022.
What does that mean for us?
Higher Short-Term Interest Rates: Remember a few years ago (2018) when you could actually get some return from a high-yield savings account or a 1-year CD? That’s expected to come back. A year from now we should see yields north of 2%. If the Fed’s longer-term expectations are realized, by the end of 2023 these numbers will be around 2.75%.
Higher Mortgage Rates: Much of this change has already happened. Six months ago, the average 30-year mortgage rate in the US was 3.0%; it now sits at 4.7%. We expect this to either reduce the rate at which home prices are increasing or cause a decrease in prices. This 1.7% increase means the annual mortgage cost of a $400,000 loan is now $4,700 higher.
Lower Realized Returns, but High Expected Returns: So far this year, we’ve seen stocks and bonds both decrease in value. The aggregate bond market is down 6.0%, and both US and International Stocks are down 5%. That’s the bad news, the good news is that expected returns are now higher! Over the last three months, the yield on bonds has gone from 1.5% to 2.5% – that’s a big deal! The math behind stocks isn’t as clean, but some of the price movement this year has come from higher discount rates which is another word for expected returns. Over the last quarter, our internal model has increased long-term expected equity returns by 0.50%.