The Federal Reserve recently raised its interest rates by a quarter point, signaling that more rate increases are on the horizon.
Despite this stance, investors are betting on only one more quarter-point increase, with some suggesting that the Fed may even cut its target range back to its current level by the end of next year.
This disconnect between the Fed’s message and what investors believe it will do poses a problem, as a drop in long-term interest rates and a stock market rally could hamper the Fed’s efforts to control inflation.
The Fed’s past behavior is partly to blame for this disconnect, as in previous cycles, it has tended to start cutting rates shortly after it finished raising them.
However, the Fed’s actions will depend on inflation and employment in the coming months.
There is a risk that investors may see the central bank’s hawkish talk as mere jawboning and that the Fed itself doesn’t believe its own message.
Despite the Fed’s recent rate hike, the S&P 500 and Nasdaq Composite closed 1.1% and 2% higher, respectively.
The stock market has been rallying since October 2022, with the S&P 500 up 17% since then and 8% since the start of the year.
There are conflicting opinions among experts on what this means for the future of the market.
Michael Burry predicts a second round of inflation spike when the Fed cuts interest rates again, while Nassim Taleb believes that the next 15 years will be harder than the previous 15 due to higher interest rates.
On the other hand, Mark Spitznagel predicts a major market crash as bad as the Great Depression.
A deeper market crash may be possible, but it is not visible at this point in time.
Historically, US midterms have resulted in positive S&P 500 performance, with a 7.3% increase after three months, a 15.1% increase after six months, and a 16.3% increase after 12 months.
Additionally, a recession is not correlated with S&P 500 performance and stock market performance after a recession is usually bullish.
The Fed has hiked rates by 450 basis points in just 10 months, far more than what was initially expected.
Ongoing rate increases will be necessary to get inflation back to the 2% target over time, with at least two more rate hikes projected in the future.
If the economy performs as expected, there will be no rate cuts this year.
The Chairman of the Fed, Powell, emphasized that there is still more work to be done with respect to inflation control and monetary policy.
The risk of doing too little is difficult to manage, while over-tightening can be addressed with available tools.
The labor market remains extremely tight, and reducing inflation is likely to require a period of below-trend growth and softening of labor market conditions.
Financial conditions have been loosening since mid-October after tightening earlier in the year, and the Fed is cautious about declaring victory in controlling inflation, viewing the job as ongoing.
Spencer is an avid globetrotter who achieved financial freedom in his 20s, while trading & teaching across 70+ countries. As a former professional trader in private equity and proprietary funds, he has over 15 years of market experience, and has been featured on more than 20 occasions in the media.
