By Tim Courtney, Chief Investment Officer
In previous commentaries, we’ve discussed how markets are natural aggregators – designed to piece multiple bits of individual information together and communicate that information in the form of a price. These prices help both consumers and investors make decisions about what to purchase based on prices. These decisions, in turn, go back to producers and other investors to help them decide what to sell. Austrian economist Frederick Hayek said that if this price system had not naturally formed but rather had been imagined and invented as a result of “deliberate human design” it would be considered “one of the greatest triumphs of the human mind.”1
This is all to say that markets provide us with valuable information. However, sometimes prices move quickly and may seem to be inconsistent or in conflict with other prices. When prices move in ways that don’t consistently communicate a clear message or discernable trend we often refer to it as “noise.” While there is always some degree of noise in price movements, they are extremely noisy today as markets are readjusting to higher interest rates and inflation for the first time in nearly four decades. Below, we examine a few examples of conflicting and noisy market signals.
Rate of inflation. The rate of inflation currently sits at around 6.0%,2 which is triple the Federal Reserve’s target of 2%. As we have seen over the last year, tamping down inflation is not easy. However, judging by current pricing the market seems unconcerned. Based on treasury pricing, the market is now projecting that inflation for the next three years will be just 2.3%.3 That is a huge deceleration in a short amount of time. However the market has consistently underestimated inflation over the last two years, so we may look at this estimate with some skepticism.
Interest rates. In January, markets were priced for the Fed to wrap up interest rate hikes and begin rate cuts.4 Equity markets and speculative investments like cryptocurrencies enjoyed a price bump at the prospect of lower borrowing and leveraging costs. It’s difficult to decipher whether those price movements provided useful information about the prospects for those investments or whether the market was simply itching for lower rates. Just this week the market fell as the Fed communicated higher rates. The market continues to move noisily as it tries to guess, second guess and third guess the Fed’s next move.5
Yield curve. The yield curve is indicating a near-term slowdown and recession. The curve is inverted with higher interest rates for short-term bonds than for longer-term bonds, which is a well-known recession indicator.6Small-cap companies and junk bonds. Historically, the most vulnerable companies in an economic slowdown are small-cap companies and those with higher borrowing costs. Those companies tend to need a growing economy to make money, and when a recession is on the horizon they tend to underperform. However, these stocks and bonds have not had the kind of contraction you might expect heading into a recession. Instead, pricing has held steady – with the notable recent exception of banks.
When the market gives us information, we don’t want to ignore it. Price signals today are extremely noisy, which is not that surprising given the events and unprecedented policy changes over the last three years. As we often conclude, the best way to navigate noisy markets is to remain disciplined and well-diversified. If you have any questions, please contact your Exencial advisor.
- Econlib (data as of 3/13/23) — The use of knowledge in society
- U.S. Inflation Calculator (data as of 3/13/23) — Current US inflation rates: 2000-2023
- The Wall Street Journal (3/23/2023) — 3 year Treasury yield minus 3 year TIPs yield
- Financial Times (2/7/23) — US stocks rise after Jay Powell’s comments
- CNN Business (3/22/23) — Fed raises rates by a quarter point
- FoxBusiness.com (3/8/23) — Treasury bond yield inversion signals economic pain
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