Some Questions Worth Pondering After Yet Another Rate Hike

There is an old saying on Wall Street. Perhaps you have heard it: Don’t fight the Fed. As in, when the Fed is cutting rates, own stocks and let the good times roll—and when it is hiking, duck and cover until they are finished. Last year, that seemed to work, as a rate hike cycle coincided with stocks’ bear market. Yet since October, it hasn’t. The Fed didn’t pause, but the S&P 500 is up anyway. It added to its nice year after the Fed raised the fed-funds target range again—and signaled more to come—Wednesday. Yet Don’t fight the Fed persists, dotting headlines with fear even ahead of this morning’s announcement, centering on those rate hike forecasts. We don’t buy it.

On October 12, the date stocks notched their most recent low, the fed-funds target range’s upper bound was 3.25%. Wednesday’s move brought it to 4.75%. In that window, the S&P 500 rose 15.7%.^[i] Now, one could argue that while the Fed continued hiking, it slowed the pace from 0.75 percentage point (ppt) in November to 0.5 ppt in December and now 0.25 ppt—and stocks registered relief accordingly. We think that cuts against the basic Don’t fight the Fed logic, and many consistently argue that logic underrates the Fed’s “determination” to hike. Others argue stocks see the Fed is fighting itself, signaling more rate hikes while market-based indicators are eyeing rate cuts by year end. We guess this niche, academic theory is more consistent with the general theme, but is kind of a stretch, given the dominant zeitgeist.

We suggest stepping back and thinking more simply. If stocks are already up despite the Fed’s decision to keep going, are we really so sure markets can’t move forward—and continue rising—without the Fed pausing? Even if the Fed doesn’t cut in the near term, might markets correctly be done with this rate hike cycle anyway, looking 3 – 30 months out to a time when the ongoing inflation slowdown has brought prices down to normal rates? Or maybe, just maybe, have we returned to the norm, where Fed rate hikes have no pre-set market impact?

To us, there is a strong case for this. The Fed might hog the spotlight, but it had a lot of competition for Dominant Fear status last year. The war in Ukraine and its feared effect on global energy, food and mining production. Western sanctions and Russian retaliation risking severe energy shortages in Europe. Accelerating inflation. The strong dollar. Supply chain snarls. Wobbling economic growth. Political rancor. In our view, it was the confluence of all these, taking turns hitting sentiment, that drove stocks below -20% last summer and autumn. When fear is the predominant force weighing on markets, you generally don’t need fundamental improvement to turn things around. Fading fear will usually suffice—sometimes because reality goes better than expected, and sometimes because the fear loses its power and people move on even though little has fundamentally changed.

We have seen this on multiple fronts already, rate hikes being one. Energy? Europe has some struggles, as we have detailed before, but it is muddling through with the lights on and factories humming. Oil and natural gas prices? Down to pre-invasion levels. Inflation? Slowing considerably, with CPI in 2022’s second half average annualized rate hitting 1.9%.^[ii] The dollar? Down from September’s generational highs. Supply chains and shipping costs? Improving—and likely to keep doing so now that China has eased most COVID restrictions. Economic growth? Iffy, but not disastrous. And those rate hikes? Ongoing but not causing credit or the economy to freeze. Loan growth remains far ahead of the inflation rate, giving the economy plenty of fuel.

That is the key, in our view. It shows the Fed isn’t in control. It can’t be, if loan growth is running over 11% y/y despite last year’s aggressive rate hikes.^[iii] There are big mistakes it could make to end the party, like suddenly and severely reinstating reserve requirements, but there is no hint of that, and it isn’t wise to position a portfolio for worst-case maybes. Those are always present. Instead, look at probabilities. If the data are clear that the Fed isn’t controlling lending, then it isn’t controlling economic growth. That makes avoiding stocks because it might continue hiking a rather big head scratcher. Forget fighting or not fighting the Fed, and try forgetting it instead.