FED rates are hiking. When are markets going to catch up?

At an FOMC meeting on July 27, the US Federal Reserve raised the interest rate by 0.75 bp. — up to 2.25–2.5%. The market expected this.

Following the Fed’s announcement, the S&P 500 increased 2.6%, while the Nasdaq Composite appreciated by 4.1%. Does this mean that the market sentiment has reversed? Almost certainly not, but the future looks rather positive for investors.

What’s next with the FED rate?

The Fed is unlikely to be able to continue raising rates at the same rate, although a 0.50 bp increase can still be expected in September. Why?

The US economy cannot develop without increasing debt. With high-interest rates, the cost of servicing debts will rise to problematic levels for the American economy.

Despite official statements about a possible soft landing, the US economy is already entering a recession. Almost all statistical data show a sharp slowdown in business activity (below are the main ones).

Recession hints

• The forecast for US GDP growth in 2022 has been lowered from 2.3% to 1.7%, and for 2023 has been reduced from 1.8% to 0.5%. Inflation-adjusted real GDP is already negative.

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• Conditions in the labor market continue to worsen, which, against the backdrop of a decrease in business activity, indicates the beginning of a recession. Although the unemployment rate remains at its historical lows, the number of initial jobless claims has been rising since the beginning of April (four months in a row).

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• An important indicator for assessing future business activity is the demand for the production of goods, which continued to decline in July and has already reached levels below 2008 levels.

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• The composite PMI index reached a minimum for 26 months: 47.5 points vs 52.3 in June.
• Consumer demand for homes in the US fell by 46% in six months. Given that the construction sector is very sensitive to the phase of business activity, we can conclude that the US economy is waiting for a further slowdown.
• The inversion of 2 and 10-year bonds reached -0.21. It should be noted that during the crisis of 2008–2009. it did not fall below -0.17.

The precursor of an economic crisis is the demand for short money. The yield curve for 3-month and 10-year Treasury bonds has shown an almost vertical decline since May.

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How markets react?

As already mentioned, after the Fed’s announcement, the S&P 500 increased 2.6%, while the Nasdaq Composite gained 4.1%. Investors positively assessed the fact that the rate was raised as expected. Also, the Fed did not increase the pace of asset sales: the balance sheet reduction will take place according to the plan outlined in May.

Does this mean that the markets started a new rally? Almost certainly not, and this is a short-lived bounce. The market is likely to remain in the current range (SP500: 3700–4100) until the September meeting of the Fed when it will then determine the further course of action.

Mentioned above statistics indicate a slowdown in business activity, it is likely that inflation may decrease in the next two months. If we hear from the FED that the inflation peak has already been passed, this will be a bullish signal for the markets even though the rate will be raised by 0.25–0.50 bp. at the same meeting.

Today’s extremely hawkish Fed rhetoric is likely just rhetoric, and in fact, we won’t see monetary tightening beyond the announced target of 3.00% (+/- 0.25) by the end of this year.

It can also be assumed that against the backdrop of the risk of a deep recession and rising debt service costs, rates at the expected levels will not last long. This also applies to balance sheet reduction. The Fed will simply be forced to turn towards a stimulating monetary policy, and we can hear the first hints of a rate cut already in the fourth quarter of this year.

This will be a positive signal for investors, and in 2023 we will see slow but steady growth in the stock market.

Nick Klenov, financial analyst