What is this Elusive Terminal Rate?
With all the financial media buzz about the importance of the Federal Reserve “terminal rate,” it begs the question…what is this elusive figure and is it as ominous as the name implies? There are many different definitions for the word “terminal.” Perhaps the easiest way to put this term into context with respect to monetary policy is to consider the terminal rate as the peak level that the Federal Open Market Committee (FOMC) will raise the Fed Funds Rate to before changing course in the current monetary tightening cycle.
Whether that change is described as a “pivot,” “pause” or all out “ending” of a rate hiking campaign, each cleverly worded headline is designed to describe the point at which the Fed takes its foot off the accelerator to observe the (lagged) effect its policy moves have had on the economy. Specifically, this means examining the factors of its dual mandate comprised of controlling inflation and employment. The tale of the terminal rate may be more enjoyable when told with a flashlight under the chin like a spooky ghost story, but for clarity’s sake, it’s perhaps best to “tip the torch” to shine some light on the actual meaning given its recent prominence in our daily financial media feeds.
MARKET INDEX RETURNS
S&P 500 Index
Russell 2000 Index
MSCI EAFE Index
Barclays US Agg. Bond Index
FTSE 3 Mo. T-Bill Index
Terminal – adjective 1. forming or situated at the end of something (a terminal date); 2. leading ultimately to death, fatal (a terminal illness); noun 1. the end of a transport route or a station (a freight terminal); 2. a point of connection for closing an electrical circuit (a battery terminal); 3. a combination of a keyboard and output device (a computer terminal)
STOCK MARKET REVIEW & OUTLOOK
Equity Markets Bounced While Bond Prices Were Driven Lower by Higher Yields
Despite a wide dispersion of returns, all sectors of the S&P 500 Index experienced a rebound in October. Energy stocks led the gains with a whopping 25% rise in the month as company management teams sat back and watched record breaking profits roll in by the truck and tanker load. Industrials (+14%) and Financials (+12%) were also particularly strong while Communication Services (0.1%) and Consumer Discretionary (0.2%) eked out modest gains. With more cyclically oriented stocks leading the charge, the once heavily followed (and it’s OK if you still do) Dow Jones Industrial Average had a particularly strong return of 14%. This was the highest monthly return for the blue chip index since 1976, well ahead of the more broadly diversified S&P 500 (8%) and NASDAQ Composite (4%) Indices.
Stock gains were able to hold, but bond prices fell with a continued rise in yields. The yield on the bellwether 10-Year U.S. Treasury ended October at 4.10%, well ahead of the 3.83% close from the prior month. The 2-Year Treasury closed the period at 4.51%. The yield curve inversion (shorter rates higher than longer-term rates) remained firmly in place as the FOMC continues to tighten economic conditions (through its statements and actions) driving short-term rates higher.
S&P 500 SECTOR RETURNS
ECONOMIC REVIEW & OUTLOOK
Economic Growth Boxed Out and Rebounded in the Third Quarter. Now Can it Drive Down the Court?
The first estimate of third quarter Gross Domestic Product (GDP) in the U.S. showed that the economy grew by a higher-than-expected level of 2.6% on an annualized basis. This comes on the heels of two negative quarters of growth in the first half of 2022. Personal consumption, government and business spending all contributed to positive growth, although net exports were the key driver. U.S. retailers imported far less during the period as they struggled to reduce inventories.
While the results were promising at the headline level, a look under the hood at Core GDP shows that there is still room for improvement which would allow for the economy to transition further down the court. U.S. Final Sales to Private Domestic Purchasers (viewed as the “core” of economic growth) fell flat in the quarter. Consumers are continuing to spend, but the pace currently looks a bit more like the over-40 basketball league than the NBA. Housing investment has continued to pull back and just how strong that ongoing headwind will be is a key consideration for subsequent revisions of the period just reported and final quarter of the year. The rise of average 30-year fixed mortgage rates during the past month to north of 7% will be playing formidable defense against a drive to normalized steady economic expansion.
CHART OF THE MONTH
Components of Third Quarter Gross Domestic Product Growth
As shown in the exhibit above, GDP growth in the latest quarter was driven more by temporary factors such as the balance of trade, rather than more durable factors like consumption and investment.
At the time of this writing, the Federal Reserve has raised short-term rates by an incremental 0.75% to a policy target of 3.75-4.00% as was widely anticipated. Somewhere between a well-crafted statement and off-the-cuff comments during the subsequent press conference Chairman Powell seemed uncertain as to whether he was to wear the dove or hawk costume from the Halloween festivities held earlier in the week. As we well know, financial markets participants dislike uncertainty and volatility was soon to follow.
Expect financial markets to continue to hand out their fair share of tricks and treats through year end. As noted, there are two sides to the volatility coin with outcomes in the short-term difficult to predict. Over longer periods of time, patient investors should be expected to be rewarded for not being spooked during times when the bears outnumber the bulls. We will be continuing to view both stock and bond markets through an opportunistic lens to take advantage of overreactions by the speculators in the crowd for the benefit of you, our clients.
Please reach out to one of your Account Officers or any member of our Executive Leadership Team to discuss topics raised in this letter or if we can assist you in any other way.
Meet The Plimoth Investment Advisors Executive Leadership Team
Steven A. Russo, CFA
President & Chief Executive Officer
Louis E. Sousa, CFA
Senior Vice President & Chief Investment Officer
Edward J. Misiolek
Senior Vice President & Operations Officer
Teresa A. Prue, CFP®
Senior Vice President & Head of Fiduciary Services and Administration