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How Investor Anticipations of The Fed, Banks, and Labor Force Affect Markets Thumbnail

How Investor Anticipations of The Fed, Banks, and Labor Force Affect Markets

The day-to-day market price swings are often more about what investors expect than the underlying fundamentals. By their design, markets anticipate future events and assign them a price today. 

This gap between reality and expectations has recently driven stock and bond market volatility due to the Fed's latest announcement and headlines in the banking sector. So, what should investors know about these developments to stay focused long-term?

First, the Fed announced on January 31 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.

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 followed by positive returns of 1.2% and 1.1% the next two days as markets quickly adjusted. Currently, markets have downgraded the path of policy rates by one cut, expecting a total of four or five by year-end. 

This is a clear case of the market getting ahead of itself with lofty rate-cut expectations. Further, 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.

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

Second, the latest worry on investors' minds is New York Community Bank (NYCB) and its deteriorating commercial real estate loan portfolio. Last year, NYCB acquired $38 billion in assets and assumed $36 billion in liabilities from Signature Bank, which failed during the Regional Banking Crisis

The chart above shows the unrealized losses in bank bond holdings that helped to spark last year's crisis, along with a slowing economy and the crash in cryptocurrencies in 2022. The other banks that made headlines were Silicon Valley Bank and First Republic, acquired by First Citizens Bank and JPMorgan, respectively.

While the banking sector has stabilized since then, commercial real estate has continued to struggle, especially in the office and multifamily segments, which make up a significant portion 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. Combined, NYCB reported a significant and unexpected quarterly loss.

Naturally, investors are worried about a repeat of last year's bank failures. While the situation is still developing, the issues facing NYCB can be characterized as a continuation of Signature Bank's problems due to higher interest rates and a slowing economy. 

This means that these issues could be bank-specific rather than reflect systemic risk across the entire financial system. Indeed, while the regional banks sub-industry of the S&P 500 has fallen 10.7% this year, the broader financials sector has risen about 3.5%.

However, systemic risks are always complex to see coming in advance, and the main program that helped banks stay afloat last Spring was The Fed's Bank Term Funding Program (BTFP). This program was a new source of liquidity that offered banks a way to gain access to cash that had previously not existed. 

It was specifically designed to help banks avoid taking on substantial mark-to-market losses (chart above) by being able to post those securities as collateral for a cash loan from The Fed. Ultimately, the new liquidity effectively staved off contagion across more of the banking sector.

However, the BTFP only offered 1-year loans, meaning banks have to come up with the cash by selling securities or taking in deposits to pay back The Fed after a year, which is coming up very soon. Further, The Fed announced the BTFP will cease making new loans as scheduled on March 11, 2024 - thereby eliminating this new source of bank liquidity.

And with the entire banking system still facing ~$700 Billion in unrealized losses and The Fed's elimination of the BTFP, the struggles of NYCB may end up being a harbinger of more stress to the financial system to come.

The job market is still historically strong

In contrast to many of 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, and the 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 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 impact individuals and households, perspective is needed when considering the economic and market effects. 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.

The labor market participation rate remains in a downward trend

However, it's not all rainbows and butterflies in the labor market. A critical measurement of how healthy the U.S. labor market and economy are is the labor force participation rate, which is the percentage of the population working or actively seeking work divided by the working-age population. 

The most current reading of 62.5% shows that labor participation has regained most of its pandemic losses. However, a very strong downward trendline remains intact. Since 2000, labor participation has been declining and reversing a significant chunk of its post-WWII increase.

While the pandemic lows in the participation rate could mark the bottom of this downtrend, if history is a guide (which it is), then we should not be surprised to see the recent low (62.5%)  to be tested again. And for it to be marked as an actual trend reversal, we would need to see that low hold (a.k.a. the participation rate cannot break to new lows in the future.

Despite recent market swings, volatility remains subdued

Of course, there is always good and bad news that investors must weigh, and it's typical that as events unfold, markets settle and expectations converge on reality. 

Interestingly, the accompanying chart shows that the VIX index, a measure of stock market volatility, is still reasonably subdued despite recent events. Investors should continue anticipating and preparing for market uncertainty by staying diversified and focused on the long run.

The bottom line: Recent Fed and banking sector events have led to market volatility, and while the banking sector has been sanguine since last spring, there may be boiling risks underneath the surface. However, current positive labor market dynamics and unexpected GDP growth continue to serve as an underlying positive force in markets.

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Matt Faubion, CFP®

Founder - Wealth Manager

This article is for informational purposes only and is not a replacement for real-life advice, so make sure to consult your tax, legal, accounting, and financial professionals if you want more information. This content is developed from sources believed to be providing accurate information, and provided by Copyright (c) 2024 Faubion Wealth Management LLC, and Clearnomics, Inc. All rights reserved. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.