Fed Is a Go for Interest Rate Kickoff

Interest rates are set to start moving higher next week.

At the conclusion of the Federal Reserve’s two-day meeting on Wednesday, it’s widely expected interest rates will increase for the first time since being cut to 0% during the pandemic. This will kick off a long anticipated tightening cycle that drives rates higher through the next year and removes liquidity from the market.

Since the start of the year, the market has struggled to accept this change in policy. Both the Nasdaq and S&P 500 declined by 10% or more prior to Russia’s invasion of Ukraine. Investors have largely grappled with the uncertainty of the pace at which interest rates will increase. Expectations have moved erratically over the past several weeks. History shows a slow and steady approach to interest rate increases is more acceptable than an aggressive path.

The speed of increases is dependent on a lot of moving parts. Hot inflation has been a key driver of the Fed’s desire to begin raising rates. Inflation emerged from a rapidly recovering economy — one that now has an unemployment rate approaching pre-pandemic lows and is still expected to grow at an above average GDP rate in 2022.

The future of the macro environment, however, has gotten murky given the turmoil in Eastern Europe. There’s fear that higher commodity prices and slowing growth resulting from the conflict, in addition to higher interest rates, could lead to stagflation.

While investors have accepted the Fed will likely begin raising rates next week, there’s still a lack of clarity on how far and how fast the Fed will move from there.

Looking Ahead

At the moment, the Fed is expected to be cautious when it comes to interest rate policy in 2022, given the conflict in Ukraine. According to the CME Group’s futures market, which prices short-term interest rates, a short-term fed funds rate of between 1.50%-1.75% is expected by year-end. That is a bit lower versus a month ago before geopolitical tensions spiked. The conflict is adding complexity to the Fed’s already difficult job. The central bank will likely remain data dependent as it makes rate decisions throughout the year. However, as we have experienced in the past, economic environments can change more quickly than the data. It’ll be all about threading the needle!

Will rising rates harm stocks?

While every rate hike cycle is characterized by a different economic environment, investors can look to history as a guide for how the stock market will perform during the imminent rate hike period. Since 1955, the S&P 500 typically performs well in the nine months after the initial interest rate increase before performance begins to moderate. This is likely because the initial rate increases are more easily absorbed as they come from low levels (0%-0.25%, in this case). Thinking longer term, remember that over the last four decades, the S&P 500 produced positive returns through six tightening periods.

Market doing the Fed’s Work?

So, is all this rate hike talk much ado for no reason? Of course not. Each economic period is unique. We haven’t experienced inflation this high since the 1980s, for one. Also consider that the bond market has done a lot of the Fed’s dirty work. Short-term borrowing rates are already up massively from a year ago. The two-year Treasury rate is above 1.6% today versus barely above 0% as recently as last fall. It’s back at pre-pandemic levels without the Fed even lifting a finger.

That type of move ahead of the Fed’s increase is unusual. Rates moving that quickly could already be reducing demand for certain consumer loans — one example is the decline in mortgage demand. With the market taking action and possibly reducing demand, the Fed may not have to move as quickly. Still, the pace of inflation will be the key driver of policy changes for the better part of this year.

Risk of stifling growth?

Given the focus on tamping down inflation, there’s a fear the Fed could move too fast and threaten growth. The recent move in Treasury rates has led to a flattening of the yield curve (where the two-year note is approaching the rate of the 10-year Treasury). An inversion of the yield curve has historically been a leading indicator of recession. GDP growth could come under pressure in the coming quarters amid high inflation and weak consumer sentiment. The conflict in Ukraine is the wild card in this scenario — de-escalation will be necessary to reduce inflationary pressures. The consumer remains on solid footing, but higher prices can quickly eat away at savings and ultimately economic growth.

Bottom Line

3…2…1…liftoff! Expect the Fed to kick off what will likely be an extended period of gradual interest rate increases next week. Most important will be the release of the Fed’s latest economic projections, where clues about the path forward will be found. So long as the Fed can execute its rate hike plans with as few surprises as possible, investors could take some solace in the history of rate hike cycles often coinciding with higher stock prices.

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Lindsey Bell, Ally’s chief markets & money strategist, is an award-winning investment professional with a passion for personal finance and more than 17 years of Wall Street experience. Bell’s unique ability to connect the dots between data and real life and craft bite-sized money ideas that people can use and apply stems from her deep background as an analyst, researcher and portfolio manager at organizations including J.P. Morgan and Deutsche Bank. She is known for demonstrating why and how an understanding of all things money improves a person’s finances and overall well-being. An ongoing CNBC contributor, Bell empowers consumers and investors across all walks of life and frequently shares her insights with the Wall Street Journal, Barron’s, Kiplinger’s, Forbes and Business Insider. She also serves on the board of Better Investing, a non-profit focused on investment education.

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