How do rising interest rates affect the stock market?
With interest rates going up this year, what’s the likely ripple effect across capital markets?
The Federal Reserve continues to pursue efforts to stem the tide of higher inflation by slowing the economy.
Since March 2022, the Fed has raised the target federal funds rate by 4.75% while gradually reducing its asset holdings.
The economy has managed to maintain positive growth despite the Fed’s measures.
Following a pattern started in March 2022 to help lower inflation, the Federal Reserve (Fed) continues to raise the short-term federal funds rate. At its March 2023 meeting, the policy-making Federal Open Market Committee (FOMC) lifted its short-term target federal funds rate to a range of 4.75% to 5.00%. In the past twelve months, the Fed significantly moved the target rate off a 0% level that it had maintained for two years – with the primary goal of fighting persistently high inflation that emerged in 2021.
At the March meeting, the Fed signaled that the current rate-hiking cycle may be close to an end. The Fed’s latest decision to raise rates came on the heels of news that a few regional banks faced financial failure. There was speculation that concerns about additional problems in the banking sector, which can affect the availability of credit in the broader marketplace, might alter the Fed’s rate-hiking strategy. Fed Chairman Jerome Powell stated that the Fed “did consider [a pause in rate hikes] in the days running up to the meeting.” In the end, according to Powell, ongoing signs of continued high inflation and strength in the labor market were factors that convinced the FOMC to approve the additional 0.25% rate hike in March.
The Fed also indicates an ongoing commitment to reversing a previous policy of quantitative easing (QE) that involved purchases of Treasury and mortgage-backed securities. QE was aimed at providing more liquidity to capital markets. The Fed began trimming its balance sheet of those assets, from its peak near $9 trillion.1 This so-called “quantitative tightening” approach, combined with interest rate hikes, is designed to temper inflation by slowing economic growth.
Inflation, which had been a virtual non-issue for decades, became a dominant concern for consumers in early 2021 and remains so today. Powell says the Fed continues to “have the resolve it will take to restore price stability on behalf of American families and businesses.” He notes that price stability is a primary Fed responsibility and seems to indicate that the Fed recognizes the importance of tamping down the inflation threat. “Without price stability, the economy does not work for anyone,” says Powell.2
The FOMC started the “tightening” process in March 2022 by raising interest rates 0.25%. At subsequent meetings, the Fed greatly accelerated the pace of rate hikes, and by the end of 2022, the fed funds target rate stood at 4.25% to 4.50%. The 0.25% rate hike in March 2023 followed a similar rate increase in early February. The fed funds target rate, now in the 4.75% to 5.00% range, is at its highest level since October 2007.3
The Fed’s actions appear to have achieved some success. By the closing months of 2022 and into early 2023, inflation showed signs of easing. Through February 2023, living costs (as measured by the Consumer Price Index) rose 6.0% over the previous 12 months, a decline of 3.1% from the peak inflation level reached in the 12-month period ending in June 2022. Nevertheless, after the March 2023 FOMC meeting, Powell stated, “The process of getting inflation back down to 2% (the Fed’s long-term inflation target) has a long way to go and is likely to be bumpy.”4
“The Fed is trying to find the delicate balance between stemming the inflation threat without having a significantly negative impact on economic growth.”
Bill Merz, head of capital market research at U.S. Bank Wealth Management
“The Fed Summary of Economic Projections indicated a terminal rate (what is expected to be the top level of its target fed funds rate for this cycle) at 5.1%,” says Rob Haworth, senior investment strategy director at U.S. Bank.
What specific actions can investors expect from the Fed going forward and how should investors prepare for the impact of these changes on their own investments?
The Federal Reserve acts as the U.S. central bank. Its functions include maintaining an effective payment system and overseeing bank operations. Investors, however, primarily focus on the Fed’s monetary policies.
In setting monetary policy, the Fed attempts to fulfill three mandates:
The Fed also influences short-term interest rates, specifically, the target fed funds rate, which is the interest rate applied to overnight loans from one financial institution to another. While Chairman Powell receives much of the attention, the FOMC establishes Fed monetary policy. It’s the committee that sets the fed funds rate target and has other authority, including buying and selling of securities.
Following its March 2023 meetings, indications from Fed projections are that one more rate hike may occur before the Fed pauses its current strategy. Haworth notes that even with the top fed funds rate currently at 5%, it’s difficult to define this as “tight” monetary policy. “The Fed is looking at inflation measures that are still higher than the current fed funds target rate,” he says. “The Fed may still need to consider necessary steps to get the fed funds rate above the inflation rate if living costs remain elevated.”
The intended impact of higher interest rates is to slow the economic activity, a strategy designed to cool off the surging inflation rate. If successful, it will likely result in weakening the job market as businesses slow hiring and investments in the wake of higher borrowing costs. However, unemployment hovers near historic lows and job openings greatly outnumber available workers. To attract and retain employees, employers boosted wages. Recent reports show that compensation costs for workers rose 4.6% for the 12 months ending in February 2023, though the rate of growth slowed in recent months. Haworth believe the Fed is closely watching the rate of wage growth to determine if it’s making progress in its inflation fight.
In the meantime, the concerns raised by news of failing regional banks could affect lending activity. The FOMC’s statement after the March 2023 meeting noted “Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring and inflation. The extent of these effects is uncertain.” Powell says, in effect, these tighter credit conditions have the same impact as interest rate hikes, which could contribute to slowing the rate of inflation.
The QE strategy the Fed implemented at the start of the COVID-19 pandemic has been curtailed. When QE was in place, the Fed purchased longer-term securities on the open market, including U.S. Treasuries and mortgage-backed bonds. These investments added liquidity and reduced borrowing costs to encourage economic activity through more lending and investment.
“Under this program, the Fed became one of the biggest buyers of Treasury securities in the market,” says Tom Hainlin, national investment strategist at U.S. Bank. “They impacted the interest rate environment just by their large presence.” Hainlin notes that with the Fed bumping up demand for bonds, long-term interest rates remained low (high demand for bonds typically helps keep interest rates lower). The Fed is now actively trimming its balance sheet.
Beginning in September 2022, the Fed is cutting back its bond portfolio by about $95 billion per month (only about 1% of its holdings each month) by not purchasing new securities to replace maturing bonds. The balance sheet dropped to roughly $8.3 trillion, down less than 7% from its peak in April, 2022.5
The process of the Fed “unwinding” its balance sheet is commonly referred to as quantitative tightening. “This means the Fed is putting less liquidity in the market, requiring other investors to generate demand for bonds,” says Bill Merz, head of capital market research at U.S. Bank. “If inflation remains an issue in combination with the Fed pulling back on its bond holdings, it could result in somewhat higher bond yields.”
The trend of reducing its balance sheet reversed quickly in March 2023 as banking sector problems emerged. The Fed responded to concerns about banking system stability by increasing its lending to banks. After the March FOMC meeting, the Fed’s official statement noted that “The U.S. banking system is sound and resilient.” Powell also pointed out that “deposit flows in the banking system have stabilized over the last week,” an indication that the need for additional Fed intervention may be limited.
The interest rate environment across the broader bond market has changed dramatically since early 2022. In October 2022, yields on the benchmark 10-year U.S. Treasury note rose above 4%, the first time since 2010. Yields on 10-year Treasuries moderated after that point, but again topped 4% in early March 2023. In an unusual occurrence, yields on shorter-term Treasury securities are higher than the yield on 10-year and 30-year bonds. At the end of February 2023, the yield on 3-month Treasury bills stood at 4.88% and yields on 2-year Treasury notes at 4.81% compared to a yield of 3.92% on 10-year Treasury notes. This is in contrast to normal circumstances, when investors demand higher yields for bonds with longer maturities.
However, after the banking problems emerged in March 2023, the bond market went through rapid changes. Yields on 2-year Treasuries, which peaked above 5% on March 8, dropped to 3.81% in less than two weeks. “It is unusual for short-term bonds to experience such dramatic price swings in such a brief period,” says Haworth. “Particularly when there was no Fed interest rate action during that same period.” 10-year Treasury yields also dropped, though not as dramatically, from a high of 4.08% on March 2 to 3.39% on March 17. The rapid falloff was the result of investors pouring money into bonds as a “flight to safety” after news of bank failures emerged. It represented a period of unusual bond market volatility, and reduced what had been a trend of generally higher interest rates dating back to early 2022.
Despite the Fed’s dramatic strategy shift, inflation remains its primary concern. Haworth points out that the economic impact of rate changes can take time. “Each rate hike will take six-to-12 months to work its way into the economic engine.” That may be, at least in part, why inflation rates have yet to ease significantly despite the Fed’s drastic policy shift.
With the Fed maintaining its focus on fighting inflation, concerns grow that its actions will ultimately lead to a recession. “There’s growing expectations that corporate earnings will suffer if the economy slows, and that factor was not priced into the stock market during its earlier setbacks in 2022,” says Haworth. “How slow the economy will get depends in part on events that are going on around us. For example, if inflation suddenly spikes up again, that could create more challenges.”
2022 was a difficult year in the investment markets, and one that had an unusual outcome. Both stocks and bonds generated negative performance for the year. Considering the Federal Reserve’s strategy shift in 2022 and what is anticipated going forward, investors should prepare for possible impacts.
Be sure to consult with your financial professional to review your current portfolio positioning and determine if changes might be appropriate given your goals, time horizon and feelings toward risk.
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