Market Update

December 14, 2022

See the impact of today’s Fed rate hike.

What’s important

• Today the Federal Reserve (the Fed) unanimously raised the Fed Funds Target Rate by 50 basis points (bps) to the 4.25%–4.50% range in a move that was well telegraphed and anticipated by the markets. In short, with today’s additional hike, rates are now well into restrictive territory to help slow inflation.

• Although this represents a downshift from four consecutive 75-bp rate increases this year, we maintain that this still represents an aggressive action in the fight against inflation. Prior to this year, the last time the Fed used a 50-bp hike was in the spring of 2000.

• The dot plot within the Fed’s Summary of Economic Projections (SEP) showed an elevated terminal rate (the level at which the Fed is expected to stop raising interest rates) of 5.1%, slightly higher than the expected 5.0% for 2023. This confirms the view that the Fed will stay at the terminal rate for some time or longer than in prior cycles.

• Fixed income and equity markets called the Fed’s bluff. Despite the Fed’s hawkish SEP data and press conference, the market was unfazed and ticked up slightly during and immediately after the press conference.

Fixed income

• Fixed income markets were seemingly unmoved by the decision and Fed Chair Jerome Powell’s comments. The 10-year treasury yield is slightly higher both on the day and since the decision was announced, as is the 2-year treasury yield. It’s glaringly obvious that the market doesn’t believe that the Fed will be able to get to 5% and maintain that level for the entirety of 2023, and the market still firmly believes that we’ll see cuts before 2024. We do believe we’re closer to the end of a rate-rising cycle.


• We remain defensive in our credit positioning, with duration short to the benchmark and higher in credit quality (as we expect credit spreads to leak wider on the expected economic weakness). We also recommend barbelled positioning, with an overweight to short and longer-dated bonds. Within tax-exempt markets, we believe essential service municipals are better positioned for an economic downturn. We prefer active fixed income portfolio management, and fundamental credit selection will offer opportunities in these volatile times.

Equities

• Equities have moved slightly lower following the announcement, with defensive segments leading. The Federal Open Market Committee statement SEP indicate expectations for higher policy rates for longer and a much softer economic backdrop than current conditions would suggest. This is in contrast to the tenets that drove market strength in recent weeks, namely that the elements conducive to a comprehensive Fed “pivot” are more imminent. With the Fed and market at odds, we eventually expect the market to digest the stark reality of a 5% terminal rate amid slower growth.


• In our view, the risk to equities remains tilted to the downside as higher rates increase the pressure on corporate fundamentals as pricing power decreases, unit growth slows and margins are squeezed. Meanwhile, higher rates improve the relative value of other yield-based assets. We continue to stress a defensive approach favoring exposure to sources of quality, yield and lower cyclicality.

Going forward

• With today’s 50-bp increase, the Fed reiterated its view that policy must be “sufficiently restrictive to return inflation to 2% over time.” While markets continue to worry that future Fed hikes will significantly hurt economic growth, the Fed continues to prioritize slowing inflation over economic growth, which will lead to longer-run economic sustainability.


• We do believe in the Fed’s commitment to fighting inflation by moving policy rates to a sufficiently restrictive level and holding them there until inflation starts rapidly moving closer to the Fed’s 2% target. Our view continues to be a 5%+ terminal rate by the first half of 2023, which aligns with the updated dot plot. Although the market is at odds with this view, we do expect capitulation eventually as the market fully digests the stark reality of a 5% terminal rate for longer and still-strong labor market.


• As markets struggle with the possibility of a 5% terminal rate, we expect volatility to remain elevated across equities and bonds. We continue to believe markets will remain data dependent as the recent November inflation report shows that inflation is starting to ease; markets will be closely monitoring future data releases as those will help guide the Fed regarding the magnitude of future rate hikes.