Historic Fed Hike Prompts Additional Market Volatility

Time to Read: 7 Minutes

On June 15, the Federal Reserve (Fed) raised the key short-term interest rate by 75 basis points (bps), the largest increase since 1994. The target federal funds rate range now stands at 1.50% to 1.75%.

The hike marked an abrupt departure from earlier guidance provided by members of the rate-setting committee, who had been telegraphing an increase of just 50 bps. The decision to implement the larger rate hike was influenced by concerns over recent inflation data—consumer prices were just reported to have risen 8.6% year-over-year—and implies the Fed sees an urgent need to combat inflation aggressively.

Here we review important context around the rate hike, including market reactions and recession indicators, and share our latest thoughts on portfolio positioning.

The Fed Ratchet Becomes the Fed Crowbar

Earlier this year, the Fed indicated it would implement a slow and steady increase in rates that would be communicated well in advance, allowing markets time to adjust. This was observed for the first increase of 25 bps and was referred to as the “Fed ratchet.” Spiking inflation over the last several months resulted in an increase of 50 bps in May. After the May meeting, Fed Chairman Jerome Powell was careful to indicate that increases of 50 bps were also expected at the June and July meetings. The dynamic shifted this week as Powell stated an increase of 75 bps was necessary in June, and that the decision will be between 50 and 75 bps in July.

The Federal Open Market Committee (FOMC) releases a Summary of Economic Projections (SEP) four times each year, which projects a range for where the Fed funds rate should be. The current median projection for year-end 2022 calls for a target rate of 3.4% (see below for the so-called dot plot). This is an upward revision of 1.5 percentage points from the SEP projection in March. The higher rate is needed to slow the economy and bring inflation down to the longer-run goal of 2%.

In addition to CPI data, the Fed also considers forward-looking expectations for inflation. Inflation tends to be a self-fulfilling prophecy, where consumer expectations for inflation in the future result in higher inflation.

Preliminary June data from the University of Michigan consumer sentiment survey show the public expects an annual inflation rate of 5.4% over the next year, up from 4.2% one year ago. Households expect inflation to run at a 3.3% annual rate over the next five years, up from 2.8% one year ago.

The Path Forward

In his prepared statements, Powell was clear about the Fed’s commitment to slowing inflation, emphasizing the plan to expeditiously move the policy rate up to more normal levels. “Over coming months, we will be looking for compelling evidence that inflation is moving down, consistent with inflation returning to 2 percent,” said Powell. “We anticipate that ongoing rate increases will be appropriate; the pace of those changes will continue to depend on the incoming data and the evolving outlook for the economy.”

He also emphasized the need for clear communication with financial market participants, noting he believes it’s helpful to provide even more clarity than usual around policy intentions—subject, of course, to uncertainty in the economic outlook—given the highly unusual circumstances surrounding inflation.

Will the Fed’s Moves Lead to a Recession?

Powell was clear that achieving lower inflation while protecting a strong labor market and a growing economy—orchestrating a soft landing—has become more complex. The Fed wants to slow the economy enough to bring down inflation, but not so much that it tips the US into a recession.

While there are signs the economy is cooling, there are not significant signs of a major recession ahead. In fact, the current Ned Davis Research (NDR) Recession Watch Report shown below displays far more signs of growth (green) than recession warnings (red). This can obviously change quickly, but for now, the economy looks reasonably healthy thanks to the strong financial condition of both consumers and businesses.

What About the Markets?

Major US stock indices have declined 20% or more, crossing the official threshold into bear market territory. Such selloffs happen, on average, about every two to three years, so this is completely normal and part of investing. As we discussed in a recent webinar, what has made this year unique is that bonds have also declined at a double-digit rate, making traditional diversification less useful.

The good news: Bonds are finally beginning to look attractive as interest rates have increased. There might be excellent opportunities once the dust settles.

As for the equity markets, the Dow Jones Industrial Average has declined approximately 20% over 5.3 months, approaching the median for non-recession bear markets, as shown below. If Fed rate hikes, higher oil prices, supply chain disruptions, higher mortgage rates, and widening credit spreads push the economy into recession, history suggests the bear market could last into 2023, and the decline we’ve experienced to date might only be two-thirds of the full picture.

Portfolio Positioning: Staying Focused on Long-Term Goals

We all recognize the damage inflation is inflicting on the economy, and, even with the risk of recession, the Fed’s aggressive moves are a positive sign. Lowering inflation as quickly as possible helps avoid the risk of it becoming entrenched, and the Fed is viewing the perception of recession as the lesser of two evils.

At Stratos Private Wealth, we cut our exposure to equities earlier this year, increased our cash equivalent position to more than 10%, and added gold to most tactical portfolios. We have also held off on rebalancing most accounts, leaving them slightly underweight equities for now.

At these levels, we believe investors with large cash positions could begin dollar-cost averaging into a diversified portfolio over a longer time frame. If we get signs of a market bottom, we will likely increase our exposure to stocks using the excess cash in our portfolios.

For now, we recommend investors try to appreciate that the current pullback is part of investing. Investors who are becoming uncomfortable are encouraged to contact their advisors. We have found that a review of longer-term financial plans and goals within the context of current portfolio values can help investors see if any significant changes are warranted. Typically, our portfolios are already well positioned, given our modeling tests for market conditions far worse than what we are currently experiencing.