What Will The Fed Do This Week? 2YR Yield Says They Should Hike!

1.) FED – The “new” Federal Reserve meets this week to decide on interest rates. New? Well, new in the sense that there is a new Fed Chair – Kevin Warsh. Everyone is wondering what his leadership at the Fed will do next?! I’m the world’s worst mind reader, so let’s just look at the facts. The 2YR Treasury is often viewed as the Fed proxy in terms of where short-term rates (i.e., Fed Funds) “should” be. Right now, the 2YR Yield is at 4.32%, down just slightly this morning. It is still in an upward trend and would have to fall to about 4.02% and stay there for that trend to break. That’s a long way from where it currently is. The effective Fed Funds rate is 3.62%. That’s a 70 basis point spread with the market HIGHER than Fed Funds. That could be viewed as a “policy error.” Historically, the average spread is just 37 basis points. So what does that suggest? It would suggest that the Fed has 1 to 2 rate HIKES in the near term as inflation continues to be high and sticky. Warsh, at his first Fed chair press conference, was pretty adamant about NOT giving any forward guidance. I think that’s a mistake. Markets never like uncertainty, but they don’t call for my opinion. Shocker…I know. Warsh is a Trump appointee, and Trump has been equally adamant that rates need to be lower, not higher. I don’t care about politics…and neither do markets. If the spread keeps widening, all it will do is increase the potential policy mistake that the market is trying to point out. The last time we saw this kind of 2YR Yield-Fed Funds spread and real rate levels was into and through the 2021-2022 hiking cycle.

2.) EARNINGS – There’s an idea at the SEC that they should change earnings reporting from once per quarter to just twice a year. More noise that is causing some to miss the point. Critics say companies will hide bad news, investors will be left in the dark, and corporate America will suddenly become less transparent. I disagree. Running a business is different than trying to manage a quarter’s earnings, which is what CEOs of publicly traded companies have been doing for decades. Every three months, they stop focusing on their company’s growth to prepare financial statements, earnings presentations, and conference calls. Those things are important, but they also take time, energy, and attention away from actually running the business. Instead of asking, “What’s the best decision for this company over the next ten years?” management starts asking, “What’s the best decision for this quarter?” Those two questions don’t always have the same answer, and managing for the “quarter” just forces everyone to become even more short-term focused. If management knows missing Wall Street’s earnings estimate by a penny could knock 10% off the stock price tomorrow morning, the temptation is to delay spending, cut investment, or make decisions that help this quarter instead of helping the business five years from now. The bottom line is that the current proposal simply gives companies more flexibility. At the end of the day, not much likely changes. All the largest companies in America will probably keep reporting every quarter because investors have grown accustomed to it. Analysts will still publish earnings estimates, and conference calls will still happen. Financial television will still spend hours debating whether a company beat expectations by three cents instead of four. Exhausting. Where this could make a positive impact is for small companies.

3.) PEG – The S&P 500 now has the lowest PEG ratio in 30+ years. A lower PEG is traditionally viewed as “cheaper” relative to growth prospects. A PEG below 1.0 is often considered attractive; the chart below shows it has now fallen to 0.81 — the lowest reading since at least the mid-1990s.

The PEG ratio gets thrown around by the bulls a bit too much, in my opinion. It’s very dependent on the growth assumption. If the consensus long-term growth forecasts are overly optimistic, the PEG can be artificially low. By the PEG yardstick, the S&P 500 is the cheapest it has been in decades relative to its expected earnings growth. Whether that makes stocks a bargain is a separate judgment that depends on how much you trust those growth forecasts. If AI capital expenditures keep ramping… then those forward growth estimates might be right. If not… well.