Stocks Are Sinking and Rates Are Rising. It’s Painful, But We’re Heading for Normal.

The Federal Reserve is raising interest rates at the fastest pace in four decades to squash the hottest inflation in just as long. Already, its target for short-term rates is up to just over 3% from closer to zero at the beginning of the year. How high will it go? Higher than inflation, surely, but the inflation rate a year from now matters more than the one for the past year. The Cleveland Fed bakes up a year-ahead inflation prediction using swaps, surveys, and bond data for ingredients. Its latest reading is 4.2%.

Or we can just watch the dots. Fifteen years ago, the Fed started publishing a quarterly chart deck of economic predictions, and 10 years ago, it added a dot plot showing where its individual participants think rates are headed. The dots are “assessments of appropriate monetary policy,” not predictions, the Fed likes to say. Good to know. The dots just shifted higher. The new midpoint prediction—I mean assessment—is that the fed-funds target will reach 4.5% to 4.75% by the end of next year.

The dots sent Wall Street into a fresh tizzy this past week. But really, they say we’re moving toward normal, not away from it. The average monthly fed-funds rate in data going back to 1954 is 4.6%. Mortgage rates are turning more ordinary, too. The 30-year fixed rate recently spiked to 6.3%, versus 2.9% a year ago. But the average in data going back to 1971 is 7.8%.

What matters for investors is whether measures like these will shoot above long-term averages, and how much is already priced into stocks and bonds. The answers are unlikely, and maybe a lot.

“The economy probably won’t be able to sustain that level of rates for any period of time,” says Michael Darda, the chief economist and market strategist at MKM Partners, about the fed-funds rate potentially hitting 4.5% early next year. The dots agree. They suggest that after next year, the fed-funds rate will fall in 2024 and 2025, by a total of 1.75 percentage points.

Darda believes that it will happen faster; he sees inflation falling toward 2% in a year to a year and a half. “Some of these slower-moving, stickier measures are going to take longer to moderate,” he says of things like wages and rents. “But they will moderate.”

Darda recommends that investors buy the iShares 20+ Year Treasury Bond exchange-traded fund (ticker: TLT) and short gold. The ETF has lost 29% this year—about six points more than stocks—and its holdings have an average yield to maturity of 3.8%. It could rise in price if inflation moderates faster than expected. The gold side of the trade has to do with Darda’s observation that although gold is called an inflation hedge, it has been a poor one, instead moving opposite real bond yields, or bond yields minus inflation.

So far this year, the yield on a five-year Treasury Inflation Protected Security has jumped from negative 1.6% to positive 1.5%. Gold should have tumbled, but it’s down only slightly. Darda reckons it has to fall to $700 an ounce or lower, or real rates have to come back down. Gold recently fetched just over $1,670. Put it together, and if Darda is wrong about the Treasury side of his trade, he expects the other side to pay off from a gold crash.

Julian Emanuel, who leads the equities, derivatives, and quantitative strategies team at Evercore ISI, has turned bullish on the same Treasury fund. He recommends buying calls and selling puts. For investors who neither trade options nor sell short, another way to interpret both of these recommendations is that it’s time to dip back into bonds.

“The 60/40 portfolio over the past two years has probably morphed into the 65/35 or the 70/30,” Emanuel says of the traditional stock/bond split. “For the first time since 2019, there is value in longer-dated bonds.”

As for stocks, what happens from here depends on whether we get a recession, says Emanuel. If not, stocks are likely near the bottom, but if so, there could be another leg down, he says.

Either way, he recommends value stocks with high free-cash yields and a record of returning plenty of cash to shareholders through dividends and stock buybacks. A recent screen for such companies turned up Bank of America (BAC); home builder Lennar (LEN); oil refiner Valero Energy (VLO); Comcast (CMCSA), the cable company; and Facebook owner Meta Platforms (META).

Now is a good time for old-economy stocks like those in the industrials, materials, energy, and banking sectors, says Graeme Forster, who runs international equity strategy for Orbis, an asset manager overseeing some $30 billion. When valuations for companies like these are low, their managers tend to underinvest, leading eventually to shortages, inflation, and rising interest rates, much as we’re seeing now, says Graeme.

“You’ll see old-economy businesses rerate upward, and new-economy businesses rerate downward,” he adds. Among his favorite stocks are Shell (SHEL), which has a big energy-trading business that is in high demand amid global shortages, and Glencore (GLEN.UK), which produces and trades key metals and is profiting from solar and wind energy storage and the shift toward electric vehicles.

Write to Jack Hough at jack.hough@barrons.com. Follow him on Twitter and subscribe to his Barron’s Streetwise podcast.