Fed all-in for higher interest rates – Natural Self Esteem

Last month’s Fed meeting minutes turned out to be something of a news bomb. As was widely reported, the Fed hiked interest rates. And in the press conference that followed, it was reported that Fed Chair Jerome Powell was more hawkish (ie likely to raise rates further). But the big news? How strong was the decision for the entire committee.

The financial world looks different now

Powell was not the only hawk in reading the transcript. It was the entire committee, including those who used to be considered deaf. What the record told us was underscored by some recent public comments from one of the former pigeons, Lael Brainard. At the end of the day there are no more pigeons.

This means that the financial world looks very different from last week. So let’s look at these differences and what they mean for investors.

Higher (and faster) rates

The shortest answer here is higher interest rates, but we knew that. The real takeaway from the meeting notes was that we will go higher and faster than expected. Many of those who attended the meeting would have preferred to hike rates twice as much, by half a point rather than a quarter point, holding back only because of the uncertainties surrounding the Russian invasion of Ukraine. Many of the participants also expect that this year there will be one or two half points. Overall, markets are now expecting about 2.5 percentage points of interest rate hikes this year – the largest annual increase since 1994. The Fed is now betting on higher interest rates and wants to do so quickly.

And it’s not just short-term rates. Even when the Fed hiked rates at the last meeting, it continued to buy bonds to push longer-term rates lower. That dissonance will disappear as the Fed now plans to shrink the balance sheet by almost $100 billion a month. The buying pushed longer-term rates lower and it is reasonable to expect the outflow to lift them. Under the expected new guidelines, both the short- and long-term ends of the curve will be pushed up – and there really will be nowhere to hide. Which brings us to the impact on investors.

What does this mean for investors?

The real economy. There are two pieces here. First, interest rates are also rising in the real economy. The biggest impact for most people is the rise in borrowing rates, with mortgage rates now above 5 percent for 30-year fixed loans. This has only just begun to hit the housing market, but the impact will only worsen over time and housing stocks have fallen as affordability has fallen sharply. Higher interest rates also affect other big purchases, including auto loans, office equipment, and anything that needs a loan. This will be a slowly growing headwind as purchases already made will be clear and not replaced.

The financial economy. Apart from the impact on the real economy, we also see the impact on the financial economy. Bonds have retreated more this year than they have in decades. Stocks have retreated as higher interest rates erode the present value of future earnings – and as the impact on the real economy also increases direct risks to those earnings. The damage is real and can get worse.

With interest rates now at the levels we saw before the pandemic, the financial environment in 2019 is likely to increasingly resemble what we saw then. Housing demand is likely to fall back to 2019 levels or even lower as prices are higher now. Stock valuations are likely to return to 2019 levels, which will create headwinds even if earnings continue to improve. The economy, both real and financial, is moving from Fed tailwinds to Fed headwinds – and that’s a big shift.

A saying you often hear in the markets is, “Don’t fight the Fed.” The Fed has been largely absent from the ring of late, even as employment and growth accelerated and inflation skyrocketed. The message from the minutes is that the Fed is back – and determined to turn inflation off. As investors, we want to make sure we don’t take those hits.

Recovery derailed?

Eventually this will very likely derail the recovery, but not immediately. The economy remains dynamic and the job market is stronger than it has been in decades. This strength allows the Fed to hike rates like this. We don’t see a recession anytime soon and markets should benefit from this continued growth. At the same time, this headwind will slow us down at some point. As always, the answer is: be vigilant, but don’t panic.

That’s the real message here: things are changing – watch out.

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