The Fed has begun to raise interest rates for the first time since before the onset of the pandemic. This is in large part due to their perceived need to combat the highest levels of inflation that we’ve seen in several decades.
Arthur Bass, Managing Director of Wedbush Securities Fixed Income – Commodities & Sec Lending Division adds, “The fixed income markets have had a dramatic move the past six months as inflation has persisted and the Federal Reserve has become increasingly hawkish. Two-year yields have risen over 200bp since November and ten-year yields have risen almost 150bp, flattening and briefly inverting the yield curve in the process. The Fed tightened 50bp at the March meeting, and markets are pricing 50bp moves at both the June and July FOMC meetings and 200bp in additional tightening by the end of the year.”
Bass adds, “While markets are pricing aggressive Fed tightening, it is interesting they are currently pricing slightly lower rates by the third quarter of 2023. The continued threat of inflation has put the Fed in a precarious position, where they may need to continue tightening even if the economy begins to weaken. That is one of the reasons equity markets have reacted as they have.”
While many Americans might agree that these moves are necessary, the stock market doesn’t seem to like them as witnessed by the steep declines we’ve seen in most major indexes over the past several weeks.
The impact of rising rates on the markets
The impact of rising interest rates has hit the stock market and other types of investments hard so far in 2022.
Through May 24, the S&P 500 index is down 17.3% year-to-date. This is on the heels of solid gains for the three prior calendar years.
Beyond more conventional benchmarks like the S&P 500, Bitcoin and other cryptocurrencies have not been immune to this turmoil either. Prices of various cryptocurrencies have taken severe hits in 2022 and many investors have suffered significant losses. Safe havens such as gold and other precious metals, as well as several other commodities, have not been immune from steep price declines as well.
This type of environment can serve to make less risky assets more favorable to investors. However, in rising rate environment investors need to take the potential impact on bonds and other fixed income investments into account.
“It’s a perfect storm for investors with nowhere to hide as Fed hikes, inflation, geopolitical issues, and worries about a recession abound,” Wedbush Securities’ Dan Ives told
Prior Fed interventions
Going back to the start of the pandemic, the Fed’s monetary policy has been supportive by keeping interest rates near zero. Additionally, the Fed’s extremely accommodative monetary policy during this period helped the stock market recover from its 2020 lows and thrive for the rest of that year and through 2021.
Since the financial crisis of 2008, the Fed has strived to keep interest rates low. This helped stimulate consumer spending that has helped fuel growth in the economy and the stock market.
At this point in time, we are seeing the Fed raise rates to try to combat inflation, and so far, the results have been very negative for the stock market.
What can a stock market drop lead to?
With the Fed’s attitude regarding interest rates changing, this could help prompt a prolonged downturn for stocks. A market downturn of any duration can lead to shifts in investor sentiment and strategies.
A significant and prolonged downturn in stocks could lead to a debt cascade due to corporations needing to resort to debt financing to finance operational and expansion needs. A growth in the level of debt on balance sheets could cause an economic downturn should borrowers begin to default on debt due to a slowing economy. This debt cascade could lead to financial difficulties for many banks which would have a very negative effect on the economy.
Do investors need to worry that all of this will lead the economy to a recession? At this point it is too early to tell.
What should investors do now?
Each investor needs to evaluate their own situation in terms of the timing of their financial goals and their tolerance for risk. Adjustments may need to be made in their portfolios.
Some assets that tend to outperform during rising rate environments have historically included short-term government bonds, value stocks and dividend paying stocks. Adding positions or expanding existing positions in these types of investments may be appropriate for some investors.
This is a good time for investors to reach out to their Wedbush financial advisor to discuss their portfolio and their overall financial plan.
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