How Expectations Around the Fed, Banks and the Economy Affect Investors

When it comes to financial markets, day-to-day price swings are often more about what investors expect than the underlying facts. This is because markets are designed to anticipate future events and assign them a price today. This gap between reality and expectations has driven stock and bond market volatility in recent days due to the Fed’s latest announcement and headlines in the banking sector. What should investors know about these developments to stay focused on the long run?

 

Rapid Fed rate hikes created stress for bonds, commercial real estate, and banks

Last week on January 31, the Fed announced that it is keeping rates steady and closed the door on additional rate hikes. However, they also stated that the FOMC would need “greater confidence that inflation is moving sustainably toward 2 percent” before cutting rates, and Chair Jay Powell emphasized at his press conference that a rate cut is unlikely at its next meeting in March. This led to a shift in market expectations around the beginning of rate cuts, leading the S&P 500 to close 1.6% lower. However, this was then followed by positive returns of 1.2% and 1.1% on the next two days as markets quickly adjusted. At the moment, markets have downgraded the path of policy rates by one cut, expecting a total four or five by year end. Clearly, this is a case of the market getting ahead of itself with lofty rate cut expectations. The gap between what the Fed has previously communicated – possibly three cuts this year – versus what the market anticipates, is an ongoing source of market uncertainty.

Separately, another potential concern on the minds of investors is the New York Community Bank (NYCB) and its deteriorating commercial real estate loan portfolio. In 2023, NYCB acquired $38 billion in assets and assumed $36 billion in liabilities from Signature Bank after it failed during the banking crisis. Last week, shares of NYCB fell about 35% after reporting a significant (and unexpected) loss and cutting its dividend in the fourth quarter, struggling to meet expectations after it purchased those assets. The accompanying chart above shows the unrealized losses in bank bond holdings that helped to spark last year’s crisis, along with a slowing economy and crash in cryptocurrencies in 2022. While the banking sector has stabilized since then, commercial real estate has continued to struggle especially in the office and multifamily segments, which also make up a significant portion (over 70%) of NYCB’s loan portfolio. Their acquisition of Signature Bank assets also pushed NYCB above $100 billion which means it is subject to higher capital and liquidity requirements.

Naturally, this can cause renewed concerns about last year’s bank failures. However, while the situation is still developing, the issues facing NYCB can be characterized as a continuation of the problems that Signature Bank faced due to higher interest rates and a slowing economy. This means that it’s likely that these recent issues are more bank-specific rather than broader problems. Indeed, while the regional banks sub-industry of the S&P 500 has fallen 2.4% this year, the broader financials sector has risen about 3.5%.

 

The job market is still historically strong

In contrast to these investor concerns, there are many signs that the economy is fundamentally strong. The latest jobs report showed that 353,000 new jobs were created in January, far more than the 185,000 economists expected. December payrolls were also revised up sharply to 333,000, bringing the average monthly gain over the past year to 244,000, a very healthy pace. The unemployment rate remains at 3.7%, one of the lowest in history. The accompanying chart above shows that while job openings have declined as the Fed has raised rates, there are still nearly 1.5 job openings per unemployed person across the country.

This is the case despite recent layoff announcements from large companies as they attempt to reduce costs and maintain profit margins. Many of these layoffs are a reversal of the rapid hiring that occurred during and after the pandemic, especially among large technology companies such as Alphabet, Microsoft, PayPal and many others. While these layoffs clearly have an impact on individuals and households, perspective is needed when considering the effects on the economy and markets. The jobs data show that while the Information sector gained “only” 15,000 jobs last month, sectors such as Professional and Business Services, Health Care, and Retail Trade added 74,000, 70,000, and 45,000, respectively.

 

Despite recent market swings, volatility remains subdued

Of course, there is always both good and bad news that must be weighed by investors. It’s often the case that as events unfold, markets settle and expectations converge on reality. Interestingly, the accompanying chart above shows that the VIX index, a measure of stock market volatility/fluctuations, is still fairly subdued despite recent events. Finally, when trying to navigate perception versus reality, it is also important for investors to take a “big picture perspective.” Between better-than-expected GDP results and strong job growth, not to mention a very resilient US consumer, the economy does appear to be in a steady and fairly robust position. This should provide investors with some confidence on where things are headed, regardless of what the Fed decides to do (or not do) or other potential headlines/events.

 

The bottom line? There is always something impacting markets in the short-term, whether it is new economic data, a geopolitical event, or some other news headline. Recent events around the Fed and banking sector are two examples that have led to some market swings. However, investors should continue to not overreact to daily headlines, remain focused on the long haul, and stay diversified in their investment portfolio.