The Fed Prepares to Make a Move

Market Memo

February 2022 – Dan Zalipski, CFA®

The markets have been volatile in the past several weeks.  The timetable for the Federal Reserve to raise interest rates continues to compress as the threat of inflation persists.  As recently as September, the Fed was indicating they wouldn’t raise rates until 2023.  Five months later, and Fed officials are openly suggesting we may see a 0.50% hike as soon as March.  In a market where quarter-point hikes are considered standard, a half-point hike would suggest the Fed waited too long to make their initial move and are now attempting to play catch-up.  Unfortunately, the Fed’s attempt to provide some relief to main street will likely cause some pain for Wall Street. 

The main culprit for the Fed’s pivot is inflation.  The topic of inflation has been front and center for much of the past year.  The debate largely centered on if the bout of inflation we were experiencing would be transitory or more persistent, with the Fed leaning towards the former.  The Fed had good reason to believe it may pass, many of the issues driving prices higher could be directly attributed to supply-chain and labor issues associated with the pandemic.  Early drivers of higher inflation over the past year were isolated to certain categories, such as used cars and raw materials like lumber.  These pressures were expected to fade as the vaccines were distributed and the world looked to normalize.  Unfortunately, the Omicron variant not only delayed normalization, but increased the pressures on an already fragile supply chain and shallow labor pool.  The latest inflation report was particularly concerning, as it showed pricing pressures broadening out from confined pockets to everyday goods, such as food and shelter. 

With inflation unexpectedly accelerating last month, the pressure on the Fed to act sooner and aggressively has increased.  Everyday Americans are feeling the impacts of rising prices.  After the latest report, some notable firms, including Citi and Goldman Sachs, both raised their forecasts for the number of times the Fed would hike this year.  Consensus estimates expect the Fed to increase rates seven times before year-end, at a pace of 0.25% per raise.  With only six Fed meetings remaining throughout 2022, seven hikes would imply one meeting would receive a 0.50% increase.  The futures market indicates investors believe that the most likely path for the Fed to take would be a 0.50% increase in March, and then a 0.25% increase at every meeting thereafter.

The rapidly changing landscape is causing the yield curve to flatten.  The yield curve is simply a way to display the yield on treasuries with differing maturities and is a popular indicator to observe, with a strong correlation between the shape of the curve and economic conditions.  The curve is typically upward sloping, with longer-dated treasuries providing higher yields than shorter-dated treasuries.  However, in times of economic stress, the curve can invert, with shorter-dated maturities yielding more than the longer-dated ones.      As the Fed prepares to raise interest rates, the shorter end of the curve begins to rise.  At the same time, concerns that rising rates may slow the economy pushes the longer end of the curve down, causing it to flatten and potentially invert.  An inversion is often followed by a recession within the next 12-18 months. 

Fortunately, the Fed has demonstrated that they are willing to pivot and adapt to fluid economic data quicker than they may have in the past.  Should conditions begin to improve and provide some relief on the inflation front, the Fed will have more flexibility to manage monetary policy and feel less pressure to aggressively raise interest rates.  That scenario would be sure to please both main street and Wall Street.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. Although general strategies and / or opinions are revealed, this post is not intended to, nor does it represent or reflect, transactions or activity specific to any one account. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All data and information is gathered from sources believed to be reliable and is not warranted to be correct, complete or accurate. Investments carry risk of loss including loss of principal. Past performance is never a guarantee of future results.