Car rates

Fed All In on higher rates

Minutes from last month’s Fed meeting turned out to be a bit of a media bombshell. As widely reported, the Fed raised rates. And in the press conference that followed, Fed Chairman Jerome Powell was flagged as being more hawkish (i.e. likely to raise rates further). But the big news? How categorical the decision was for the all Committee.

The financial world is now different

Reading the minutes, it wasn’t just Powell who was warmongering. It was the whole committee, including those who were previously considered doves. What the Minutes told us was further underscored by some recent public comments from one of the doves of yesteryear, Lael Brainard. At the end of the day, there are no more doves.

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

Higher (and faster) rates

The shorter 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 at the meeting would have preferred to raise rates twice as much as they did, by half a point rather than a quarter point, and they resisted only because of the uncertainties surrounding the Russian invasion of Ukraine. Many participants also expect one or more half-point hikes to come this year. In total, markets are now expecting rate hikes of about 2.5 percentage points this year, the largest annual increase since 1994. The Fed is now all in with higher rates and wants to do it quickly.

And it’s not just short-term rates. Although the Fed raised rates at the last meeting, it continued to buy bonds in order to drive down longer-term rates. This dissonance will disappear, as the Fed now plans to reduce the balance sheet by nearly $100 billion a month. The purchases have lowered longer-term rates, and run-off can reasonably be expected to drive them higher. Under the expected new policies, the short and long 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 rooms here. First, in the real economy, interest rates are also rising. The biggest impact for most people is the increase in lending rates, with mortgage rates now exceeding 5% for 30-year fixed loans. It’s only just begun to hit the housing market, but the impact will only get worse over time, and homebuilding stocks have fallen as affordability has fallen sharply. Higher rates will also affect other major purchases, including auto loans, business equipment, and anything else that requires a loan. It will be a headwind that will slowly grow, as the purchases already arranged will be clear and will not be replaced.

Financial economics. Beyond the blow to the real economy, we also see the impact on the financial economy. Bonds have fallen more this year than in decades. Equities have fallen as higher rates erode the present value of future earnings and the impact on the real economy also increases the direct risks to those earnings. The damage is real and could well get worse.

With interest rates now at pre-pandemic levels, in 2019 the financial environment should look more and more like what we saw then. Housing demand is expected to return to 2019 levels or even decline as prices are now higher. Equity valuations are expected to fall back to 2019 levels, creating a headwind even as earnings continue to improve. The economy, both real and financial, is moving from a Fed tailwind to a Fed headwind – and that’s a big change.

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

Has the recovery gone off the rails?

At some point, this will most likely derail the recovery, but not immediately. The economy still has substantial momentum and the job market is stronger than it has been in decades. This strength is what allows the Fed to raise 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 eventually slow us down. As always, the answer is to be vigilant but don’t panic.

That’s the real message here: things change, pay attention.