Rate Hikes and Market Moves: Analyzing the Fed's Strategy | Episode 173 | 09-16-24

What if history could predict the future of our economy? This is an eye-opening discussion on the implications of the Federal Reserve's latest moves, and why their aggressive interest rate hikes could be a double-edged sword. We'll uncover why this tightening cycle is one of the most intense since 1945, and reflect on how previous cycles have led to significant economic downturns. Was the Fed behind the curve from the start? What are the real Fed funds rates telling us now?

Don't miss our detailed analysis of how these policy shifts are already influencing the stock market, especially the S&P 500's unexpected performance. Is the market overly optimistic about upcoming rate cuts, or is caution warranted? Break down the numbers, historical trends, and what this all means for future economic conditions. Tune in for a look at the Federal Reserve's past, present, and possible future, and how investors should navigate these turbulent times.

Well, the much-anticipated Fed Day is upon us. This week, on Tuesday and Wednesday, the Federal Reserve Committee will meet, they'll discuss monetary policy and then on Wednesday, we'll get announcements on what they are going to do with interest rates, as well as getting not only a press conference, but we will be getting new economic assumptions and also new dot plots where we can get a better idea of how many interest rate cuts the Fed officials are looking for over the next year. So in our weekly this week we just wanted to take a step back. Let's look at the tightening cycle that we've been through. What does history tell us around tightening cycles? And then what does it tell us around easing cycles? And then, specifically, what's priced into the market? So let's dig into some of these fun facts. And again, this is just looking at history as a guide. This is just history. All of the economic environments that surrounded different tightening cycles and easing cycles were all very different than they are today. But it is kind of a fun exercise to take a look at what history may tell us about some of these different tightening and easing cycles. So, first of all, the tightening cycle that we have been in, going back to 1945, it's the fourth longest stretch that a Federal Reserve has actually remained on hold. It's been about 14 months before they started cutting interest rates. This is also what we've seen is it's been one 14 months before they started cutting interest rates? This is also what we've seen is it's been one of the most aggressive tightening cycles, going back to 1945, the median average of interest rate hikes that we get in a tightening cycle is 225. But with this one we got 525 basis points in just about 17 months. This is one of the most aggressive, not only in that magnitude of rate hikes, but also in the length that they did this. There were only two other tightening cycles going back in history. That was in 1973 and 1980, where they were raising interest rates at a similar magnitude and as quickly as they did. Unfortunately, both of those did end up in deep recessions. Now is it time.

If you look at real Fed funds rates, so typically this is the Fed funds rate, which takes into consideration inflation. Many would say that the Federal Reserve was behind the curve in hiking rates in the beginning of this anyway curve in hiking rates in the beginning of this anyway. Typically, the Fed starts raising interest rates in a tightening cycle when the real Fed funds rate is about 0.55%. So you have a positive real Fed funds rate, so they're going to typically have started raising rates then. But if you go back to when the Fed started raising interest rates in this cycle, that real Fed funds rate was actually negative 8.25%. So that's why you have many people saying that they were behind the curve already. Now, as being aggressive as they were, and with inflation coming down, they now have the real Fed funds rate at about 3%. If you look back at past tightening cycles, typically they start to you see that peak real Fed funds rate at about 2.3%, so that would argue that it is time to make some tweaks to monetary policy. On the negative side of this, though, typically the Fed's too late. 60% of the easing cycles that we've looked at since 1945 have resulted in a recession, because the Fed comes in after the economy's already slowing. So having an orchestrating a perfect soft landing is not the norm. It's actually the abnormally.

Now the most important thing, though, whether they cut interest rates 25 basis points or 50 basis points at the meeting on Wednesday, what is the equity market pricing in? And one of the interesting statistics is that, if cut interest rates 25 basis points or 50 basis points at the meeting on Wednesday. What is the equity market pricing in? And one of the interesting statistics is that if you go back to all of the easing cycles, typically the S&P 500 is up only it's actually negative. I'm sorry. It's usually negative in the 12 months leading up to the first rate cut. Well, in the trailing 12 months through Friday, the S&P 500 was up 28%. So this would argue that the S&P is already pricing in these rate cuts and maybe a little too optimistic about it.

Now, what does this all mean? In summary, our view, whether it's 25 or 50, what is the market pricing in? We can use history, we can look at this and it can be a fun exercise to see and try and have some consistency and data on where we may see equities go from here. But in reality, what we're looking at when it comes to investing is what is the economic environment? Right now, we're talking about a slowing economic environment. Inflation has gotten a lot better, but we talked last week about how some areas of inflation are still stubborn. We have political risks as well and we also have a consumer that is very stretched right now. So equities, where they are, are sitting not far from record highs. Valuations are stretched across many areas of the equity market. It may be pricing in too much optimism. This might be one of those situations where we sell on the actual news, so we expect volatility to pick up.

What we're going to be looking at at this meeting on Wednesday, as we mentioned, dot plots what do they think GDP? What are they thinking about inflation? What are they thinking? Do they think GDP? What are they thinking about inflation? What are they thinking about the labor market? What are they thinking about the long-term neutral rate for the Fed funds? These are the things that are going to be market moving on Wednesday. That's all we have today. We'll be back tomorrow because we'll get the last significant piece of economic data, which will be the retail sales report, and then we'll be back on Wednesday to report our findings from the Fed's results from the meeting. Now, if you like this podcast, please subscribe, share this with friends or colleagues, hit that alarm bell that's at the bottom, and if you'd like a further history of our podcast, you can go to marketswithmegan dot fm. Thank you.