In the purest definition, the price of a stock is the present value of future earnings. We arrive at that present value by assuming a discount (or interest) rate expected to prevail over the time period of those earnings. The lower the interest rate, the higher the present value and vice versa. In reality, stock prices move in reaction to a multitude of factors; but that doesn’t mean interest rates aren’t important. Hence, why market participants are drawn to Federal Reserve FOMC meetings like moths to a light. This week’s meeting was no exception.

 

At issue is when interest rates are going to start climbing from their near generational lows and how high they will go. A perfectly-working crystal ball would answer both of these questions and give us a perfect line of sight to how future earnings should be discounted. Unfortunately, that crystal ball has been cloudy for a while, ignoring the elephant observation in the room – that no one has a clue where future earnings are going to be anyway.

The one thing that most agree on is that US rates aren’t going to start moving higher until the Fed starts down the path of reducing the amount of bonds it is grabbing out of the secondary market each month (currently $120 billion). This is referred to as “tapering” and, for those that remember 2013, you will know that tapers can become tantrums. Fed Chair Jerome Powell doesn’t want a tantrum, but he also indicated this week that the wait time for tapering to start won’t be long either. In the press conference following Wednesday’s FOMC decision, Powell said that the Fed could begin cutting back on bond purchases as soon as November and finish tapering by the middle of next year.

 

 

 

Based on that guidance, it is definitely possible that the Fed will start to hike its fed funds target rate sometime in the second half of 2022. I remember back in the summer of 2020 when analysts were suggesting that rate lift-off could happen by the end of this year, but a few more waves and variants took that off the table. Still, there were some that couldn’t reckon a move on rates until we got into 2023. This is what makes a market and I think the market is about to get more interesting.

 

Let’s take a look at where traders think the Fed’s official rate will be next year. Like other securities, there is a futures market for the fed funds rate and we refer to it as the 30-day Federal Funds Futures. Each contract will refer to a specific month down the road and it will be priced at a discount to 100. In other words, if the contract were priced at say 99 for a certain month, it would be implying that markets expect a 1% fed funds rate (100 minus 99). Now, it’s important to realize these futures contracts are merely giving a point in time insight into market expectations – they are not an actual forecast.

 

 

In terms of providing a guide, based on fundamentals, they are useful. So, when does the market think the lift-off in interest rates will begin? The June 2022 fed funds contact reached a low of 99.84 earlier this summer, before people started to worry about the Delta variant. That level implied about a 60% probability of a quarter-point rate hike by the middle of next year. Around the same time, the December 2022 contract, however, implied about the same probability of a half a percent increase rates by that point in time. Even if we take the December 2023 fed funds contact, the market is only pricing in a full percentage point increase in rates. Think about that. In over two years from now, the street still thinks that rates will be up only a percent.

 

Before we get too excited by that apparently slow and modest creep higher in rates, consider that when we came out of the 2008-2009 financial crisis, it took the Fed 7 years before it started to hike and 8-1/2 years before the effective fed funds rate got back to 1%, around the middle of 2017. If current futures contract pricing turns out to be accurate, we will have achieved this in just over 3-1/2 years. After breaking 1% in 2017, it took about 15 months before the Fed moved rates to 2%. At the pace implied by the futures market, it may only take until the summer of 2024 before we are back to 2%.

 

 

What this means is that the time frame to get back to pre-Covid rate levels could be very much compressed relative to the last cycle. Does this mean that the current bull market in stocks is living on borrowed time? I would say no, since it wasn’t the move in the fed funds rate above 2% that caused stocks to break down in 2020 – it was Covid. If you consider the break higher in stocks this week after the FOMC meeting, it would appear that investors have the same belief. Marginal rate hikes just because the economy is returning to full employment is not the same as when the Fed punishes the economy for overheating.

 

Even the bond market is starting to behave normally again. The 10yr US treasury yield broke above 1.4% this week for the first time since July as investors repositioned from fixed income to equities. Rather than bonds selling off on fears of runaway inflation, this was a rational shift that also takes into account a more defined timeline to when the Fed is going to pull back from bond purchases. I think the Fed actually starts this process at its December meeting, which means it will go from buying $120 billion in bonds to no bonds by the middle of next year. Instead of buying $720 billion in bonds in the first half, it will add only $420 billion to the balance sheet. Emphasis on the word “only”. This is hardly monetary policy tightening and so any tantrum in the bond market will likely be contained. It doesn’t mean that the equity market isn’t vulnerable to outside risks, whether from the virus or an energy crisis in Europe, but as Jerome Powell nears the end of his first term, he isn’t going to be the reason why stocks lose their cool.