Will the Fed Really Do Whatever It Takes?

As we enter fall, investors are watching the 10^th month of prices head south for the winter. This has resulted in one of the highest bearish investor sentiment readings in three decades, currently at 61%.  Since the 1980s, this barometer has only reached these levels twice before. Most investors seem ready to hibernate and wait for spring. Even the housing market has cooled and has now had several months of price declines, (the longest since 2007 to be exact). Considering mortgage rates have more than doubled in just a few short months, it leaves you wondering how bad things are about to become. What follows are a few “observations” as to why it is not a given that this will be a long cold winter.

 

 

Most would agree that inflation is the culprit for our current problems in the financial markets (you might be thinking of Russia, but that only fueled the inflation flame). The Fed has stated it will do whatever it takes to bring inflation down, but does it have the resolve?

 

 

According to the Office of Management and Budget at the White House, the government anticipates $4.4 trillion of revenue in 2022. Including interest costs on the national debt, the government expects outlays of $5.8 trillion, which equates to a $1.4 trillion deficit. Currently, the total national debt hovers around $30.9 trillion, with an average maturity of roughly five years. If you consider that 5-year treasuries had a yield of 1.35% at the beginning of the year, that would indicate interest costs of $405 billion for the U.S. government. Now that interest rates for 5-year treasuries have risen to 4%, that same calculation results in debt payments of almost $1.2 trillion, potentially increasing the deficit by $800 billion going forward. If interest rates reached 6%, debt costs would soar to $1.8 trillion. In that case, interest costs alone would approach almost half the current federal budget, not to mention the subsequent increase in mortgage rates that are already at 6.3%. It’s unlikely that the Fed wants the housing market to crash given how foundational it is to a healthy economy. Therefore, between ballooning the federal deficit, real estate affordability, and ever-present political pressure, the Fed is relatively restricted on how far they can continue to hike. Will they really do whatever it takes? Anything is possible, but it will come at a cost.

 

 

Will these costs be as deep as 2008? While the rhetoric from the Fed and media outlets is similarly negative, there are some key differences between then and now. In 2008, when mortgage rates were close to 6.5%, it wasn’t hard to walk away from a house that had negative equity. You had some confidence that you could replace that mortgage in the future, so why continue paying for a house that you were underwater on? Today, how confident are you that you can replace a 3% mortgage anytime soon? In this environment, you’ll probably do everything you can to hang on to that rate. To put this into perspective, going from a 3% to a 6% rate on a $500,000 mortgage is a difference of about $100,000 in payments over 10 years. If mortgage rates exceed 8% (less than 2% higher than the current 6.3%), the additional payment becomes $200,000. Since interest rates have been historically low for several years now, most homeowners have had a chance to refinance to a rate close to or even below 3%. Even if your house declines by $100,000 in value, you will think twice before walking away. This key factor indicates that if the economy does take a hit sometime soon, the impact is highly likely to be different than in 2008. Rest assured, it will be anything but easy to predict.

 

 

If you still think all of these factors point to one conclusive end, keep the following in mind. As mentioned, bearish investor sentiment is currently around 61%, the third worst since the 80s. In 1991 it reached 67%, however, one year later the stock market rallied by 32%. In March of 2009, the sentiment was 70% bearish, but the following year saw a 68% rally. Here, the news was still horrible and predictions were almost all bad, yet prices stopped going down and the market nevertheless turned up. This is not to say that everything is about to get better but to point out that what seems obvious almost never is. If the Fed came out tomorrow and said “we’re pausing rate hikes for a few months,” what effect might that have on stock prices or the housing market? It would seem most investors would behave as though they see a light at the end of the tunnel. The only problem is, you won’t get that memo ahead of time.

Observations On The Market No.375