Don’t Hold Your Breath: Rates Aren’t Coming Down Anytime Soon

If you’ve been hoping for interest rates to fall this year, I’ve got some bad news for you: borrowing costs will likely only go higher from here.

At least, that’s what we’ve been hearing from various Fed officials over the past couple of weeks. More specifically, these individuals have been telling us that the central bank should continue raising rates into the foreseeable future, and the fact is that incoming data supports their case for future rate hikes.

To this point, inflation data for January showed that prices accelerated at a faster-than-expected rate, rising 0.5% on a month-over-month basis. What’s more, the data also show that US labor market conditions remained robust in January, as employers added over 500,000 jobs to their payrolls, besting economist expectations of a slowdown.

And if that wasn’t enough to dash the market’s hopes of lower interest rates this year, government data just recently showed that households spent at a faster-than-expected rate of 6.4% last month compared to a forecast of 4.5% for January.

If we’re in a recession at this moment, then this is possibly one of the strongest economic environments we’ve experienced in a while heading into the start of an economic downturn. This perspective is relevant because history tells us is that the Fed tends to pause interest rate hikes as the data begins to turn to the downside. And so far, while there is some evidence of slowing economic activity, the data does not yet make a solid case to prevent policymakers from raising rates higher from here.

Hope for a Fed Pivot (Continued)

Now, if you’ve been following along with the markets, you likely know that some investors anticipated interest rates to rise only modestly this year. Thereafter, the hope was that the Fed would pause its rate hike cycle and eventually begin cutting rates by year-end as the expected recession unfolded.

This market narrative was a key factor driving risk asset outperformance in the first couple of months of this year. Indeed, US stocks in January had one of their best starts to the year in a long time on hopes that the Fed would eventually pivot away from aggressive rate policies and pave the way for a market rally this year.

For example, at the start of the year, markets were pricing in 0.25% rate increases by the FOMC in February and March, followed by a pause in rate hikes and then an eventual rate cut by year-end.

Nevertheless, as January came to a close and key economic data began rolling in for the month, it became clear that economic conditions do not yet warrant rate cuts this year.

Indeed, the incoming data suggests that a severe economic downturn hasn’t presented itself yet if we look at the health of the household as a key barometer of activity. To be sure, this activity is critical to note because nearly two-thirds of gross domestic product (GDP) is made up of household spending alone!

From this perspective, a case can (and in some instances already has) be made that policymakers will need to continue raising rates until something breaks in the economy or financial system that would eventually warrant a rate cut.

So, then, what are some conditions that likely need to be present for policy rates, and hence borrowing costs, to fall later this year? For now, developments in the housing and labor markets likely will be critical indicators for confirmation that economic conditions have slowed to levels that support lower inflation over the near-term, which could give policymakers the cover they need to take their foot off the policy brakes.

Housing Market Developments

And why is housing a critical factor in the Fed’s rate calculus?

Well, that’s because what happens in the housing market is critical to measures of inflation. That’s because housing costs, as it relates to its contribution to overall inflation, make up a sizable portion of the consumer price inflation (CPI) basket. Indeed, over the past couple of years, owner’s equivalent rent, or the cost of housing, has skyrocketed from an average rate of around 3% from 2010 to 2020 to nearly 8% in January of this year.

What this means is that it’s becoming more expensive for households to pay to keep a roof over their heads as the cost of servicing a mortgage has risen and average rents nationally continue to climb. And while activity in the housing market has slowed over the past year, incoming data show that conditions have actually stabilized.

For example, while inventories of new and existing homes went up mid-last year as buying activity slowed as the Fed began raising interest rates, the number of homes available for sale presently is falling back to levels we last saw just a year ago. What’s more, homebuilders’ sentiment improved in January at a better-than-expected rate as homebuying activity remained resilient in the face of rising borrowing costs.

Resilient Labor Market

And shouldn’t have rising borrowing costs killed consumers’ appetite for homeownership?

Well, one of the reasons why homebuyers have remained resilient is because wages continue to rise and hiring in many parts of the labor market remains robust. Data released in early February showed that employers added another 500,000 jobs in January, nearly double the rate that many economists had predicted for the month.

And with interest rates rising and the economic outlooking seemingly so uncertain, why would we continue to see more jobs added from one month to the next? Or, put a different way, why is the labor market still so strong even when other indicators have suggested for months that the US economy could be headed for a recession?

While there is a myriad of explanations for this uncertainty, the fact is that there are many demographic shifts that have taken place over the years that have led to a stubbornly strong labor market today.

For example, even in the pre-pandemic era, employers had been looking for qualified workers and had difficulty filling open positions. This reality is exhibited in the upward trend in JOLTS time series data. And given that employers were once challenged to bring on new workers, they’re likely less willing to let go of these same workers even as slowing economic conditions put pressure on margins.

And recently, with prices increasing and labor market shortages abounding, business owners have used inflation as a cover to raise the prices of their goods and services, pay higher wages, and pass those costs on to consumers. Indeed, in January, average hourly earnings grew x.x%, a slowdown from nearly 6% in early 2022 but remains well above the less than 3% average over the past decade.

What this means is that households increasingly have more money to spend as employers pay new workers higher wages or offer outsized cost of living adjustments to existing employees as a means to keep them on board.

What it Means for the Markets

The conditions that would have justified just two more rate hikes this year and that led to a solid risk-asset rally in January are likely no longer present. To be sure, as it stands today, market participants are, in fact, pricing in three more rate hikes this year. What this means is that we’re likely to see heightened market volatility in the months ahead as investors look for a new narrative to support the nascent cyclical bull market rally for the year.

So, what factors will market participants likely be watching to evaluate market direction looking out into the rest of the year? Well, as recent data have demonstrated, the health of the consumer will likely be central to the market narrative this year. And directional data points relevant to these measures include resilience in the labor and housing markets.

The hope is that as activity in these sectors of the economy begins to weaken, so will inflation. And as inflation data (which tends to lag as an indicator of price momentum), confirms what the housing and labor market tells us, investors likely will have the confidence they need to move ahead of policymakers once again and drive risk-asset prices higher.

What it Means for Your Finances

Until then, we continue advocating for an investment strategy that is consistent with your long-term risk tolerance, goals, objectives, and, most importantly, your financial plan. Indeed, now may not be the time to take on additional investment risk. In fact, given the strong rally this year and renewed macroeconomic uncertainties, we continue advocating for a disciplined cash management plan, especially for those investors who are currently drawing down on their savings to fund their post-employment living expenses.

Outside of investing, it’s vital to note that financial markets are pricing in rates to go up another 0.75% this year. What’s more, policymakers have indicated the interest rates likely will need to stay higher for longer. Therefore, if you need to borrow to make a purchase, consider your options as the potential to refinance at lower rates likely may not come for more than a year or more from now.

On the flip side, higher interest rates have finally made it beneficial for individuals to hold cash. While the purchasing power of cash continues to be eroded on an inflation-adjusted basis, you now have more options in today’s environment to put your money to work in a relatively risk-free manner.

For instance, many financial institutions now offer savings and Certificate of Deposit (CD) accounts that pay interest of over 4.5%. This reality is especially salient given that if we are headed for a recession in the second half of the year, then preparing an adequate cash buffer to weather an economic downturn is essential now more than ever.

Make no mistake, borrowing costs are only likely to go up from here. As a result, we’re likely to see higher levels of market volatility and economic uncertainty in the months ahead. That’s why even after a solid start to the year in the markets, it’s essential to avoid financial complacency. Indeed, taking a few steps right now to position your finances properly likely will put you one step closer to mastering your journey to financial independence.