What Comes Next? (Hint: There Are Reasons to Be Optimistic)

DEWITT, Mich. - Sept. 27, 2022 - PRLog -- The Fed was firmly in the driver's seat for the markets this week, with the stock market recoiling and interest rates moving higher as investors digested the prospects for more aggressive rate hikes ahead as part of the Fed's mission to bring down elevated inflation.  We'd highlight three developments last week:

1. The Fed hiked its policy rate by another 75 basis points (0.75%) and raised its outlook for potential additional hikes ahead.
2. The stock market revisited bear-market territory, giving back summer gains.
3. Interest rates rose to their highest in more than a decade.

On the surface, the conditions above probably don't instantly inspire a positive response; however, history, an assessment of key factors, and a broader perspective offer a more favorable outlook. Market pullbacks are never comfortable, and this renewed market weakness may have you feeling anxious about the road ahead. But we'd note that the conditions behind last week's developments provide worthwhile reasons for investors to be optimistic about what comes next.

Fed hiked rates by 75 basis points (0.75%)

What changed?

• Last week's 75-basis-point rate hike from the Fed was widely anticipated, but stocks moved lower in response to the Fed's comments on its outlook for further policy tightening.
• Market expectations quickly shifted, with an expectation that the fed funds policy rate will now peak north of 4.5%, leaving more than another full percent of rate hikes ahead¹.
• The Fed moved the goalposts on upcoming rate hikes, catching the markets off guard and increasing fears of recession. Our economic forecasting model has pierced the threshold that has historically signaled a recession, which looks increasingly likely to us as the impacts of tighter monetary policy work their way through the economy.  This does not, however, mean an eventual recession has to drive further downside, as markets are already pricing in a recessionary outcome.

What comes next?

• While monetary-policy tightening phases can be painful for stock- and bond-market returns, we think we are closer to the end of the Fed's current campaign than the beginning.  Historically, when the Fed's policy rate peaks, market performance is quite strong in the 12- and 24-month periods that follow¹.
• We think moderating inflation will provide the Fed with some flexibility in the months ahead, meaning it may not have to tighten as aggressively as last week's reaction suggests. The Fed typically shifts to a more accommodative stance as economic conditions weaken.  Thus, signs of a recession, while unwanted, could enable the Fed to pivot in 2023, which we think would be a positive for market performance.

Sources: 1. Bloomberg