Special Market Update – September 22, 2022

Yesterday the Federal Reserve Board (Fed) voted unanimously to raise rates by three-quarters of a percentage point bringing the federal funds rate to 3.00 – 3.25%.  More importantly, updated forecasts for future rate increases reflect a more hawkish path through 2023. 

We now expect another 75-basis point hike at their next meeting in November, followed by a 50-point hike in December.  Additional, albeit smaller, rate hikes will likely continue into 2023.  As of today, 12 out of 19 FOMC members expect Fed Funds between 4.50% and 5.0% by the end of next year.

Simply put, Fed officials now expect rates to remain higher for longer.  If there is a silver lining to all of this, it is that historically the Fed has an awful track record of predicting the future path of inflation and interest rates.  Just one year ago, the Fed proclaimed that inflation would be transitory (falling to 2% by the end of 2022) and that they were unlikely to raise rates until 2024.  How did that work out for them?

We must also remember that the Fed is very focused on managing expectations.  They want financial conditions to remain tight (low stock prices and elevated interest rates) until inflation begins to break.  That is the main reason why Powell was extremely hawkish in Jackson Hole and now again in the September meeting.

All of this certainly explains why the equity markets are under pressure with the major indices such as S&P 500 and Nasdaq trading just above their June lows.  The risks of a Fed policy mistake are rising, and we now expect stocks will retest those levels with further downside in the days ahead. 

The Fed finds itself in the difficult position of battling inflation as the economy shows clear signs of slowing and they now appear willing to sacrifice economic growth for lower inflation.  The Fed’s new forecast for 2023 GDP growth is 1.2% with an unemployment rate of 4.4%.  We have long believed the Fed was very late in recognizing the surge in inflation, and now they are attempting to make up for lost time even if it risks pushing the economy into recession.

The question now is, have we reached peak hawkishness with nearly all relevant players expecting rates to go much higher.  Leading indicators for both the economy and inflation are showing sharp decelerations and we believe inflation peaked earlier this year.  We expect inflation, growth, and interest rates will move below current expectations in the next 3 to 12 months.

Even as economic activity is slowing at a more rapid clip because of the Fed’s tightening, the economy is not collapsing.  If inflation turns out to be decelerating faster than many currently believe, as is our perspective, the Fed may not have to go as far as they are now forecasting.  This would be welcome news for equity markets, but it will take time to play out.  The best thing investors can do today is remain focused on their planning horizons and not panic.

Please let us know if you have any questions or would like to schedule time with us to dig deeper into our outlook.  As always, thank you for your continued trust and confidence in Clearwater Capital Partners.