The Reaction to The Fed’s Decision Will Be Felt Beyond the Markets

“It’s not the heat, it’s the humidity.” This overused cliché uttered by Americans during summer heat waves is a light-hearted remark designed to cope with environmental misery. But the phrase also can be useful as a metaphor in other arenas, such as the U.S. economy and the financial markets.

Of course, in the real world, summer eventually turns into fall and eventually winter, offering relief from the heat. In the stock market, even though trends eventually reverse, in the heat of the moment, it’s the market’s reaction that sets the tone for what’s next, often with little relief for many.

By the time this article is published, the Federal Reserve will have made its intentions known regarding its plans for the future of interest rates. The markets will have moved. In a complex world, ripples in ponds may turn to tsunamis. Tsunamis have long-lasting effects.

While the odds of another rate hike are nearly zero, the financial markets are focused on what the central bank says regarding the timing of rate cuts. The odds of what the market was hoping for, the first of as many as six rate cuts for 2024 starting in March, have slowly faded, which means that the focus will now be on any hint of a rate cut as soon as possible after March.

The Lay of the Fed’s Land

The most recent Beige Book, the Fed’s periodic summary of national economic activity featuring data collected before January 8, 2024 painted a cautionary picture. Seven of twelve districts reported unchanged conditions – ongoing flatness mostly. Of the four districts that reported change three reported “modest” growth and one reported a “moderate decline.”

Some areas of the economy showed increased activity during the holiday period while manufacturing was down in most districts. Employment was essentially flat except in Boston and San Francisco where skilled labor conditions were described as “tight,” with auto mechanics and experienced engineers cited as exemplary of the trend. More recent data suggests that workers are less willing to leave their jobs, a sign of rising anxiety.

In addition, in the Beige Book the Fed noted: “nearly all Districts cited one or more signs of a cooling labor market, such as larger applicant pools, lower turnover rates, more selective hiring by firms, and easing wage pressures. The pace of wage growth was characterized as moderate in Boston, Richmond, Chicago, and Dallas; as modest in New York and Philadelphia; and as slight in St. Louis. Firms from many Districts expected wage pressures to ease and wage growth to fall further over the next year.”

More recent data from the Dallas Fed suggests that the Texas economy, which had been a bright spot for the U.S., is starting to stumble. Specifically, the survey cited a fall in company outlook and general business activity while wage pressures rose along with capital expenditures. The situation is perhaps best summed up by a rise in the Outlook Uncertainty metric which rose to 20.9 from the prior reading of 18.3. This is the 33rd consecutive month of climb registered by this indicator.

Where the Market Stands

Prior to the Fed’s decision, the S&P 500 (SPX) and the Nasdaq 100 (SPX) were near their recent highs. Earnings misses from Microsoft (NSDQ: MSFT) and Alphabet (NSDQ: GOOGL) may weigh on the index in the short term. 4700 is the key support level to watch.

Perhaps the most important market to analyze is that of U.S. Treasuries. That’s where the bellwether, the U.S. Ten Year Note yield (TNX) comes in handy since it’s the benchmark for mortgage rates which are the primary influence for the housing market, aside from supply and demand.

Ahead of the Fed’s announcement TNX was tumbling in response to a reduction in the Treasury’s future borrowings and signs that private payrolls are stumbling. TNX is testing the tight yield range between 3.8 and 4.2%. Note the cluster of activity above and below the 50 and 200-day moving averages. A move outside this trading range will be pivotal for the markets and the economy. Things can change rapidly after the Fed’s announcement and the upcoming payroll numbers.

What 41 Percent of the economy is Saying

I often think of the U.S. economy as a house with the Federal Reserve serving as its caretaker and money supply as the water and important lubricants which keeps the economy flowing. When the Fed eases rates, water flows easily – the house runs smoothly. Higher interest rates tend to clog the pipes, which eventually leads to the buildup of mold and rot, leading to foundation problems.

Together, the housing (think foundation) and transportation (think plumbing) sectors account for as much as 21% of U.S. GDP. The financial sector (the homeowner’s income source) accounts for another 20% of GDP. As a result, what happens in these three industries in response to what the Fed says and does shapes the economy. This is especially true of the stock market, a major influence of a person’s ability to borrow money through its influence on the value of their 401-k plans; an important variable in the loan decision making process used by banks.

Currently, based on information gleaned from recent earnings reports, major players in two of these three industries are struggling. This is important, not just to stockholders, but to each company’s employees and customers, as well as how their behavior in response to events affects spending patterns and the economy.

For example, United Parcel Service (NYSE: UPS) recently delivered a disappointing earnings report. The company cited its labor dispute and the uncertainty it caused with its customers – some abandoned their relationship with the company fearing that their packages wouldn’t be delivered – as a reason for the miss. In addition, UPS lowered its future guidance. What the company didn’t say is that UPS employees demanded higher wages in response to the negative effects of the Fed’s policies on their pocketbooks. UPS announced 12,000 layoffs after the earnings report.

The price chart speaks for itself.

Last week, in this space I pondered whether the earnings miss by homebuilder D.R. Horton (NYSE: DHI) was indicative of a worsening situation for the housing market. When I dug even deeper into Horton’s earnings, I discovered that part of the company’s miss might have been attributed to an interest rate hedge, which Horton briefly mentioned but did not fully describe as causing a $65 million hit to the quarterly earnings.

On the other hand, a hedge gone wrong is not likely to account for lower sales and what seems to be a rise in DHI’s inventory. These two developments are more likely the result of how the Fed’s rate hikes have influenced Horton’s potential customers, many looking for starter homes, and the ensuing effect of how their decisions to delay buying a new home affected Horton’s board room decisions – thus the hedge to protect against lower earnings caused by higher interest rates. The hedge backfired as bond rates plunged in Q4.

In both cases, higher interest rates led to negative results for the companies, which resulted from the Fed’s actions and their effect on the real economy.

It’s Not the Heat. It’s the Humidity.

The bond and stock markets will likely move decisively after the Fed’s next interest rate decision. Even if the central bank leaves rates unchanged, what they say about their future intentions will affect prices.

As any homeowner knows, the chain of complexity which governs the wellbeing of any house is nearly infinite. And as important as the market’s reaction may be, housing, finance, and transportation account for nearly one half of the U.S. economy.

The markets will fluctuate. Outside the market, the effects of Fed policy seem to have more meaningful and often lasting effects.

When the Fed acts, mortgage rates will react to the bond market’s response. 401k plan values will rise and fall with the stock market, perhaps changing the outcome of a pending mortgage loan. Companies will make spending decisions. Orders for equipment which affect the operations and plans of other companies will be finalized or cancelled.

As the ripples in the pond expand, employment situations will change. Some will lose their jobs and will have to change their financial plans. Those decisions will affect others along the economic chain.

For investors, the market will eventually find some balance. But in the real world, even if the heat eventually cools, the mold and mildew engendered by humidity, if left un-remedied, can eventually cause home foundations to falter.

If the Fed surprises everyone by lowering rates, then things will get very interesting in a hurry.

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