April 2024 Market Commentary

A Change of Pace

We highlight the bond market's long history and how the Federal Reserve's monetary policy influences everyday interest rates. Irrational investor behavior is not confined to the equity markets. Mr. Market is alive and well at 75 years old. The equity market's winning streak is at risk if history is a guide.

The U.S. bond market and all major equity markets generated positive returns in March. The S&P 500 Index, the Dow Jones Industrial Average and the NASDAQ Composite Index were all up for the fifth consecutive month. The Energy sector gained 9.6% in March, while the Materials and Utilities sectors each increased 6%. The Consumer Discretionary sector was the only sector to decline in March, registering a 0.3% loss.

"Never try to time the bond market. Anyone who claims to know the future of interest rates is certifiable."

-Jane Bryant Quinn

Bonds in Focus

Bonds have a long history. The first government bonds were issued by the Bank of England in the late 1600s to finance a war against France. Bonds were issued by the American colonies and the Continental Congress to finance the Revolutionary War. After gaining independence, the newly formed American government issued bonds to redeem outdated Continental currency. The modern U.S. government bond market started during World War I. [i]

Today, the U.S. bond markets are the largest in the world, valued at over $50 trillion. The largest bond submarket, the U.S. Treasury market, has doubled in the past decade and now is approximately half of the total U.S. bond market. The U.S. government bond market is considered the most liquid and efficient fixed-income market in the world. The interest rate paid by the U.S. government to its borrowers (i.e., bond owners) is considered to be the "risk-free" rate and is a benchmark for millions of securities and other kinds of transactions around the world.

[ii]

What Monetary Policy means for Bond Investors

In addition, the Treasury market is known as the mechanism by which the Federal Reserve (the Fed) executes monetary policy.  Since 1977, the Fed has operated under a mandate from Congress to promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates. In the broadest terms, monetary policy works by spurring or restraining growth of overall demands and services in the economy. [iii]   The federal funds rate (FFR) is one of the Fed's key tools for guiding monetary policy. When overall demand slows relative to the economy's capacity to produce goods and services, unemployment tends to rise, and inflation tends to decline. To stimulate growth, the Fed can lower the FFR, known as an easing of monetary policy. Conversely, when overall demand is too strong, unemployment can fall to unsustainably low levels and inflation can rise. The Fed can keep inflation in check by raising the FFR, known as tightening of monetary policy.

The FFR impacts everything from yields on savings accounts, to interest rates of credit cards, mortgages and most loans. Yields on short-term Treasury bonds and the FFR track each other very closely. Movements in the policy rate are associated with similar movements in short-term interest rates. The graph below depicts the relatively tight correlation between the rates over the past 50 years.

However, the correlation between the rates has drastically changed over the past year. The yield on a 2-year Treasury security is 63 basis points (one basis point equals 0.01%) below the FFR and yield on a 1-year Treasury security is 33 basis points below the FFR.

Irrational Exuberance in the Bond Market

What gives? Because the Fed's monetary policy is data dependent (using unemployment and inflation data), the divergence in yields may suggest the bond market and the Fed have disagreed on the state of the U.S. economy for the past year. Last Spring, the rapid rise in yields indicated that the bond market believed the economy was running too hot.  Additional rate increases were anticipated. But since October, the pronounced drop in yields reflects a bond market's view that economic demand is fading. Multiple rate cuts were anticipated. However, the FFR has remained unchanged since July, despite the rise and fall of short-term bond yields. Investors trying to time the bond market have failed.

For a closer look at how the market is currently positioned, we turn to the CME Group's FedWatch tool. This tool acts as a barometer for market participants to gauge the markets expectation of potential changes to the FFR while assessing potential Fed movements around the Federal Open Market Committee meetings.[iv] The table below indicates that there is a 50% probability the Fed will reduce the FFR by 25 basis points at the June 12^th meeting. By year end, there is a 33% probability the FFR will be at 4.63%, a level below the current yield of both the 1-year and 2-year Treasury bonds. Although we will abstain from making predictions on year end interest rate levels, we do expect investor anxiety to continue this year. Rising investor anxiety will likely lead to terrific opportunities to capture mispriced bonds for long-term ownership. We intend to be diligent and proceed when appropriate.

Mr. Bond, meet Mr. Market

Benjamin Graham introduced Mr. Market to investors 75 years ago. As described in his book The Intelligent Investor, Mr. Market is a hypothetical Investor who is driven by a range of emotions, prone to make investment decisions based on erratic swings of pessimism and optimism. Graham's advice to investors was to make rational decisions based on fundamentals rather than allowing emotions to play a deciding role.  By conducting thorough research and analysis, Graham believed investors can determine the true value of a company based on earnings, net assets, growth potential, and competitive advantages.

Clearly, today's stock market is not the stock market of 1949.  The sheer size of the market is astounding. The total market value of the U.S. stock market reached $50 trillion at the end of last year. Company information is easily accessible and universally distributed instantaneously.  All things being equal, the average investor is far more informed today than 75 years ago.

Long Live Mr. Market

Nevertheless, emotions continue to influence investors' decisions. Mr. Market is present. Look no further than the plights of GameStop, Peloton and WeWork. Irrational investor behavior pushed valuations of these companies to shaky levels based on mind-boggling growth assumptions. Unrealistic optimism trumped fundamental analysis. In the short-term, investors were rewarded. But over time, fundamentals triumphed. WeWork filed for bankruptcy, and GameStop's and Peloton's market values declined 87% and 98% from its pandemic-era peak, respectively.

Our investment philosophy is deeply rooted in a belief that the market is emotional in the short-term, but rational in the long-term. We acknowledge the market evolved, and will continue to evolve, but believe Graham's advice is relevant today. We resist crowd psychology, addressing fears when others are panicked, and stay grounded when others are greedy. We understand trying to keep pace with the market in all environments leads to poor investment decisions.

Looking Ahead

As we stated last month, we expect the equity markets will likely continue to climb a wall of worry, with a keen eye on the Fed's monetary policy. If economic activity and corporate earnings continue to surprise on the upside, the probability of rate cuts will likely fall. If so, the major U.S. equity indices five-month winning streak may be at risk of ending. Pockets of irrational behavior have emerged, as expected. If history is any guide, a market correction is a possibility. Similar to our take on the bond market, we believe irrational behavior will lead to terrific opportunities to manage mispriced equities.

We appreciate your confidence and support and hope you reach out to an Old Point Wealth Management team member with any questions.