August 26, 2023 Market Update

The U.S. stock market rebounded for the trading week through Friday, August 25.  The 0.8% gain for the S&P 500 Index marks its first weekly advance in a month.  It’s too soon to say if the rise signals that the recent market weakness – the longest stretch of selling so far this year -- has run its course.  But perhaps investors are becoming a bit more comfortable with the various risks that continue to weigh on market sentiment.

One narrative making the rounds for interpreting Mr. Market’s latest activity: Friday’s rally was partly fueled by Federal Reserve Chairman Jerome Powell’s economic comments yesterday at the central bank’s summit in Jackson Hole, Wyoming. “The economy may not be cooling as expected,” he said.  “So far this year, GDP [gross domestic product] growth has come in above expectations and above its longer-run trend, and recent readings on consumer spending have been especially robust.”

Good news for stocks, at least in theory, because stronger growth suggests that worries about recession were overblown.  On other hand, if the economy is stronger than recently expected, inflation may stay higher for longer and convince the Fed to keep interest rates elevated and possibly announce more hikes at some point.

Speaking of macro factors that cast a long shadow over investor sentiment, R-star (a.k.a. R*) is the latest buzzword making the rounds on Wall Street.  It refers to a “goldilocks” inflation-adjusted interest rate that neither stimulates nor restricts future economic growth or inflation.  The relevance here is that this so-called natural rate of interest has implications for how the Fed will adjust monetary policy. 

A number of recent R* estimates suggest that the current Fed funds target rate (5.25%-5.50%) is restrictive (because R* estimates are lower) and therefore high enough to reduce inflation.  Ergo, the case for more rate hikes appears weak and support for cutting rates is strong(er), or so R* implies. 

But R* is unobservable directly and so models are needed for estimates – models that come in a wide variety.  In turn, debate abounds on what the correct R-star rate truly is.  For example, a recent paper by Vanguard researchers suggests the neutral rate may be more like 1.5% or 2.0%.

Encouraging because it suggests the Fed can ease up, but that’s not necessarily what central bankers think.  “I don’t see us as having a really clear and precise understanding of what the neutral rate is and what real rates are,” Fed Chairman Jerome Powell said late last year.

The elusiveness of the R-star rate makes the Fed’s decision on where interest rates ought to be that much tougher.  It is also why I caution against adopting an investment strategy that relies heavily on interest rate forecasts.

That’s all for now.  Have a great weekend, and invest wisely my friends.

Yet the bond market calmed down this past week after the recent run-up in the benchmark 10-year Treasury yield.   Following five straight weeks of rising, the 10-year rate eased fractionally to settle at 4.25% on Friday.  That’s still close to the highest level since 2007, but the fact that the yield fell despite Powell’s comments on Friday suggests that the market remains cautiously optimistic that inflation will continue to ease and rate hikes are behind us.