Fed follows through

A perspective from E*TRADE Securities 05/04/22

On Wednesday the Federal Reserve raised interest rates for the second time this year, increasing its benchmark fed funds rate 0.5% to a target range of 0.75–1%. The move followed a smaller (0.25%) hike in March, as well as indications the Fed would trim its balance sheet by roughly $90–$100 billion per month.1

In raising rates by 0.5%, the Fed followed through on its pledge to combat inflation by aggressively tightening monetary policy—despite lingering uncertainties about the impact of Russia’s invasion of Ukraine, new COVID lockdowns in China, and a struggling stock market.

Morgan Stanley Wealth Management has argued that inflation may have peaked, and growth concerns may begin to eclipse interest rate concerns and the current focus on the Fed.

Why it matters

When the Fed raises interest rates, the effects ripple throughout the financial system and the economy: For example, mortgages, auto loans, and credit card rates become more expensive for consumers, while businesses also pay more to borrow the money they need to fund their operations or expand. That tends to make both consumers and businesses a bit more conservative about their spending, which may then cool the economy and, hopefully, drive down the prices of goods and services.

Potential market impact

The flipside of this coin is the risk that attempting to tame inflation by raising rates crosses the line from cooling a too-hot economy to freezing it, which could pressure corporate earnings and, ultimately, stock prices. Also, higher interest rates can make fixed-income investments like bonds more appealing relative to stocks (although they can negatively impact existing bond holdings), and when demand for stocks wanes, the market can go down. Historically, though, the longer-term connection between rising interest rates and falling stock prices is much less concrete than many people think.

Moving forward

A few thoughts for investors as we head deeper into this tightening cycle:

  • Two down, six (or seven, or eight) to go? The Fed has signaled it intends to raise rates after each of its five remaining policy meetings this year, with hikes likely extending into 2023. Aside from the ongoing challenge it will face in terms of acting too timidly vs. too aggressively, there’s also the issue of how much the market has already priced in these increases, and whether other factors will exert a greater influence on the markets.
  • Looking beyond interest rates. The mixed earnings season may be highlighting one shift in the market. Morgan Stanley Wealth Management, for example, argues that inflation may have peaked, and slowing growth could emerge as the primary headwind for stocks.2 In other words, growth concerns may eclipse interest rate concerns and the current focus on the Fed.
  • Potential upside. The interest rate picture isn’t just about the Fed, and it has a potential upside for investors. The sharp, across-the-board jump in rates that has unfolded in recent months is beginning to provide attractive yields in some areas of the fixed-income space.

Rising interest rates are important, but they shouldn’t distract investors from their long-term goals. Similar to the Fed’s balancing act, investors need to remain even-keeled in their approach to the markets, starting with a balanced, diversified portfolio.

Note: The Fed’s next policy meeting is scheduled for June 14-15.

1 Bloomberg.com. Fed Officials Weigh Pruning Balance Sheet by $95 Billion a Month. 4/6/22.
2 MorganStanley.com. U.S. Stocks and the Oncoming Slowdown. 4/25/22.

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