No happily ever after yet for stocks
Last week, the US Federal Reserve decided to stay on hold, keeping their interest rate at 5.5 percent amid moderating employment gains and tightening financial and credit conditions.
Due to growing speculation that rates have already peaked, the US 10-year bond rate fell by a total of 26 basis points last week to close at 4.57 percent on Friday.
The US and global equity markets (including the Philippines) responded favorably, with the S&P 500 rising 5.9 percent week-on-week and the Philippine Stock Exchange index (PSEi) increasing 0.5 percent. The dollar also weakened, helping the peso appreciate slightly to P56.10 as of this writing.
Although the Fed’s decision to keep rates unchanged is good news, I don’t think it is compelling enough to trigger the start of a bull market.
While interest rates may have already peaked, I would like to stress that the Fed has no plans to cut rates either as it wants these to stay higher for longer. It still finds inflation very sticky and far from the 2-percent target.
At its current level of 5.5 percent, the interest rate on dollar assets remains significantly higher than where it was (at 0.25 percent) before the Fed started raising rates in 2022.
Like the Fed, the Bangko Sentral ng Pilipinas (BSP) is very hawkish as it did an off-cycle rate hike of 25 basis points in the last week of October. This was in response to inflation accelerating in August and September due to rising food and oil prices. Although the magnitude of rate hikes by the BSP here at home is not as big, it is still significant at 450 basis points with the benchmark rate coming from a low of 2 percent.
Higher rates are bad for economic growth as it discourages consumers from spending. The resulting increase in the cost of borrowing also discourages businesses from expanding, limiting the potential growth in profits and the number of jobs that can be created.
For example, due to the significant jump in mortgage rates, the number of existing homes sold in the US fell to 5 million in 2022 from 6.1 million in 2021. The number continues to fall to a seasonally adjusted annual rate of just 3.9 million as of September.
Locally, loan growth has been trending lower, falling to 7.2 percent in August from a peak of 13.7 percent in December. Moreover, rising rates work with long and variable lags. Higher rates only impact new borrowers, borrowers with floating rate loans and borrowers with refinancing needs.
Note that because of the Fed’s aggressive rate hikes, the shorter-term, 2-year bond rate went above the 10-year bond rate beginning in July last year. Historically, the US economy had suffered from a recession every time the yield curve inverted. However, the time it took from the beginning of the yield curve inversion to the start of the recession ranged between six months and 33 months, averaging 18 months.
As of this writing, it’s been 17 months since the 2-year bond rate first exceeded the 10-year bond rate. Although the US economy has been resilient so far, a recession could still happen anytime soon.
Numerous indicators are already pointing to a possible recession including the continuous weakness of the Conference Board US Leading Index Ten Indicators and the tightening of financial and credit conditions.
The heightened risk of a recession will make it difficult to convince investors to buy stocks aggressively. The availability of short-term fixed-income products that provide very attractive yields makes the job even more difficult.
Although an oversold rally could materialize in the short term, a more sustainable bull market is only possible once the Fed starts cutting rates.
In the past, the stock market only bottomed when the Fed was already close to ending its rate-cut cycle. Unfortunately, it is still not yet clear when the Fed will start cutting rates. As such, it might take a while before we can see a more sustainable recovery of the stock market. INQ