Federal Reserve Legerdemain
March 24, 2025
Since late February, the equity market has sold off as much as 10%, spooked by an increased probability of trade tariffs being implemented and leading to a global trade war. Such a development could be both inflationary (leading to higher prices for consumers) and recessionary (leading to layoffs and an economic slowdown). The Federal Reserve, in its attempt to thread the needle against this recipe for “stagflation” (slowing economic growth with stubborn inflation), has decided to attack the yield curve from both ends. In the short end, it has decided to keep rates “higher for longer”, thus talking up its inflation-fighting bona fides. At the same time though, it has decided to lean on longer-term interest rates (typically set by supply/demand), by significantly scaling back the amount of US Treasurys it will allow to “roll off” its balance sheet.
The Fed’s goal with this sleight-of-hand is to buy time for some of the near-term uncertainty surrounding tariffs and their potential impact on growth and inflation to play out, while communicating to speculators that risk-taking is still encouraged.
While we don’t have an opinion on how successful this move will be, it has certainly bought the Fed some time to gauge whether inflation or a weakening labor market should be of greater concern. The equity market pullback had led to a somewhat healthy rotation among sectors, which could broaden the market’s strength longer term.
This revised macro environment has only served to reaffirm our portfolio positioning. With the US 10-year Treasury note now comfortably below our 4.5%+ yield threshold for adding positions with a 5-10 year maturity profile, we will continue to add positions in the 3-5 year maturity window. The “higher for longer” stance of the Federal Reserve for short term rates should slow the decline in short term rates a bit, thus extending our buying opportunity set. For equities, given our preference for below market risk stocks (as measured by beta), we welcome the equity market correction but will continue to be patient in putting new capital to work.
The following section includes some more detail on our thoughts on the markets.
In the last four weeks, the stock market has gone from an all-time high to retreating about 10%, as a result of an increased realization that a global trade war may be upon us. A myriad aggressive import tariffs proposed by the Trump administration now appear more and more likely to materialize, albeit in a targeted fashion. It is not surprising, therefore that the euphoria surrounding the release of “animal spirits” following the election results in November is finally being tested by the reality of some of the administration’s proposed policies.
Until this about face in investor sentiment in late February, the singular concern about the equity market was its frothy valuation, particularly in the information technology sector which has grown to accounted for more than 30% of the market value of the S&P 500 (up from around 20%-23% historically). The resulting pullback has so far felt primarily in the sectors most geared toward continued economic growth.
Although certainly rapid in speed this time around, the market’s roughly 10% contraction is not uncommon. Since 2000, the S&P 500 has experienced approximately seven 10% or greater pullbacks. Of these, all but one were related to structural economic changes or shocks: the “dot-com” bust (three years of negative returns – 2000-2003), the Financial Crisis of 2008, and the Covid pandemic of 2022. The only other negative year was 2018 following the continued interest rate increases by the Federal Reserve.
The key question in investors’ minds currently appears to be whether a recession is back on the table, upending the most-recently previously held opinion that the Federal Reserve had orchestrated the perfect “soft-landing”. Near term stock market performance is often a humbling reminder that the stock market “sees the future” much better than most professional investors. Since we have yet to devise a crystal ball better than the market itself, we withhold taking a strong stand. What is clear is that a prolonged market pullback can become a negative feedback loop to consumer confidence, which up until recently was quite jubilant. In absence of “trade wars” talk, we believe the underlying strength of the US economy is quite strong. If the US is now faced with a recession ahead, it appears it will be somewhat “manufactured” by US politics rather than a speculative bubble bursting (such as the “dot-com” and the Financial Crisis). This would be similar to an exogenous shock, such as the Covid pandemic, or the determined Federal Reserve of Paul Volker in 1980 to finally break inflation through persistent increases in interest rates (fueling the deep 1982-83 recession).
We believe the US consumer can handle a bit more pessimism from current levels, but not much. Therefore, how the tone of trade negotiations play out over the next few weeks could be key on whether the US enters a recession. On a positive note, the drop in long term rates can help lower 30 year mortgage rates, leading to refinancing activity and renewed consumer spending. With many sectors still up for the year, we believe prudent investing in equities for those with long-term horizons can make sense.
The Federal Reserve, in response to the increasing likelihood of trade tariffs pressuring growth while potentially stoking near term inflation, has committed to keeping short-term rates unchanged for now. This confirms the “higher for longer” expectation of the market. Nonetheless, the Fed is also feeding the animal spirits, by its just announced decision to scale back the “run-off” of its US Treasury bond holdings. Instead of allowing for a monthly net $25 billion of holdings reductions, it now will only allow a $5 billion monthly net reduction. Given the size of its $6.75+ trillion balance sheet, $5 billion is essentially zero, in our opinion, meaning the Fed is essentially communicating to the market that long term rates will be supported, leading to a rally in long term bonds while alleviating banks’ funding pressures. This will fuel risk taking once again, and in our opinion, more than offsetting the “higher for longer” stance with short term rates.
Please feel free to reach out to us with any questions or comments.
Dimitri Triantafyllides, CFA
Chief Investment Officer
dtriantafyllides@forestcapital.net
704-533-9876 (office)
This report is for your information only and is not an offer to sell or a recommendation to buy the securities or instruments named or described in this report. Additional information is available upon request. The information in this report has been obtained or derived from sources believed by Forest Capital Operating Company, LLC (Forest Capital) to be reliable, but Forest Capital does not represent that this information is accurate or complete. Any opinions or estimates contained in this report are current as of the date of the report and are subject to change without notice.
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