Our January 2022 newsletter was titled "New Paradigm" because we noted that the sudden shift in the Federal Reserve's rhetoric regarding interest rates was a game changer. Interest rates are the price of money, and that price was going to go up.
The consensus coming into last year was that growth would come in at three to four percent, interest rates would rise modestly as the Fed started a hiking campaign, and inflation would moderate as the supply chain got back online. Analysts expected stocks to rise roughly 10 percent.
None of that came true. Growth was negative in the first two quarters of the year and, while it did improve in the second half, it didn’t come anywhere near three or four percent for the full year. The Fed didn’t just hike rates, it raised them higher and faster than ever before. And, of course, stocks were down 20 percent for the full year (and 30 percent for the tech-heavy Nasdaq). Inflation ended the year at 7 percent, helping to push bonds down 17 percent.
This chart from Bianco Research shows clearly what an outlier stocks and bonds both being down together by that magnitude was. Note that the data goes back to 1802.
As unprecedented as the move in the bond market was, it leaves savers in a much better place than in the past few years. CDs, Treasury bills, and short-term bonds are yielding close to five percent after being around one percent this past year. And due to longer-term rates being lower than short-term rates, it is safer investments offering a better return that is a true anomaly.
We've talked over the past year about this situation of interest rates on longer dated bonds being lower than short-term rates, known as a yield-curve inversion. It's garnering a lot of attention because historically, every time this has occurred, a recession has followed (although the timing of that recession has varied--anywhere from three months to two years). Stocks and other investment assets do not perform well in recessions.
Is it a foregone conclusion? Maybe not. The research linking the inverted yield curve to recession was done in the late '80s by Campbell Harvey for his dissertation at the University of Chicago. But today, everyone knows about the yield curve and that common knowledge may have changed people’s behavior so much that the curve is no longer as useful (h/t Alhambra Investments). Even Dr. Harvey doesn't believe it is viable in this environment.
It's also hard to see a recession with the employment numbers we've been seeing. Last week the government reported that U.S. employers added a solid 223,000 jobs in December, evidence that the economy remains healthy even as the Fed is rapidly raising interest rates to try to slow economic growth and the pace of hiring. The unemployment rate fell to 3.5 percent, matching a 53-year low.
Lastly, I would just point out that back-to-back down years in stocks are fairly rare although that did happen in the dot com bust when 2000, 2001 and 2002 were all negative. Before that, you have to go back to 1973-74, 1946-48, 1939-41, and 1929-1932. (Bonds have never suffered back-to-back annual losses.)
The caveat is that stocks didn't really begin to recover in those markets until the Fed stopped raising interest rates. In 2022, the Fed made seven consecutive increases to its benchmark lending rate, including a 0.5 percent hike in December that brought its rate into the 4.25-4.5 percent range. The first Fed meeting of 2023 takes place next month, and the consensus is that another increase is in the cards.