Fed Raising Interest Rates – 5 Scenarios To Help You Decide What To Keep

Brown bear (Ursus arctos) looks out of its den in the woods under a large rock in winter

Byrdyak

The Fed announced another 75 basis point hike yesterday, bringing Fed funds rates to 3-3.25%. Even more worrying, Fed Chairman Powell stated the Fed’s intention to “keep at” their battle to beat down inflation. It seems he is quite fond of using this language – at Jackson Hole on August 26, 2022, he said literally the same thing “we must keep at it until we are confident the job is done.” The hawkishness was anticipated in the previous piece here.

This has led to the sharpest increase in interest rates in decades, as shown below, you’d have to go back to the early 1990s for something comparable.

interest rates

interest rates (FRED)

The Fed’s median projections shown below also expect higher interest rates compared to the projection made in June 2022: the median Fed fund rates in 2023 and 2024 is expected to be 4.6% and 3.9% respectively and still remain at 2.9% for 2025.

Fed economic projections (Jun-22)

Fed economic projections (Jun-22) (Fed)

This is contrary to the projections made in Sept 2021, just 1 year ago, where interest rates were expected to be at 0-1% for the next 2 years (the June projection below is compared against June 2021 which forecasted c.0% rates till 2023).

Fed economic projections (Sep-21)

Fed economic projections (Sep-21) (Fed)

This is certainly not to mock anyone – the economy and the situation keeps changing. But what seemed like endless money printing from 2008 to 2021 ended abruptly this year, so situations can change rapidly.

Other than keeping at combating inflation, Powell also said “we actually think we need a period of growth below potential in order to create some slack”, the problem is, no one actually knows how much slack is needed. Is it 0.6% extra unemployment as the latest projections indicate above enough? Or does it take longer and more? The uncertainty hangs overhead until there is clarity.

Here are five scenarios to ponder, just as a thought experiment

Scenario #

Bullish/bearish for equities

Scenario details

Scenario 1

Most Bullish

Inflation quickly declines, economic growth recovers.

Scenario 2

Moderately Bullish

Inflation slowly declines, soft landing for economy

Scenario 3

Bearish

Inflation slowly declines, deep recession

Scenario 4

Most Bearish

Inflation does not noticeably decline or even accelerates, deep recession

Scenario 5

Wildcard

Inflation appears to decline and economic growth recovers but inflation accelerates again.

I have plotted Federal funds effective rate(%) and change against previous year for real GDP, PCE (ex food and energy) and CPI together). Let’s see if we can find a precedent for these scenarios. I will use S&P 500 and Nasdaq index instead of the ETFs (SPY and QQQ) respectively, as the histories of the indices go back longer.

Interest rates, GDP and inflation

Interest rates, GDP and inflation (FRED)

S&P 500 1960-2022

S&P 500 1960-2022 (Public info)

Scenario 1: Inflation quickly declines, economic growth recovers.

In this scenario, inflation suddenly declines as geopolitical tensions evaporate and natural gas prices fall to pre-war prices. Needless to say, this scenario seems quite unlikely at this moment.

In the early 1990s, the Fed hiked rates from 3% to 6% in a year. Inflation turned out not to be a credible threat. The S&P was flat (450-500) during this tightening and then soared after the Fed ended tightening. While the bull market was driven by the internet boom, the low point post bubble in 2003 was still c.800, significantly higher than when the Fed was tightening.

Scenario 2: Inflation slowly declines, soft landing for economy

In this scenario, inflation slowly declines as slack builds up in the economy. Economic growth does not head into a deep recession or a recession at all.

In the early 1970s:

  • From 1968 to 1970, interest rates increased from 5% to 9%. S&P 500 oscillated between 90-100 and did not really crash.
  • By mid 1970, S&P 500 fell to 70s as the economy slid into a minor recession. Then interest rates were cut to around 3% over the next year, inflation fell to c.3% and stocks hit a high of 118 in 1972.

Scenario 3: Inflation slowly declines, deep recession

This was experienced in the early 1980s where inflation declined over two years as the economy went into a double dip recession.

Interestingly enough, the stock market didn’t do too poorly during this period. Perhaps after a decade of disappointment it was already desensitized. After a bear market that lasted about the first half of 1982, the S&P 500 began the infamous bull market by August 1982. The index in 1982 was relatively unchanged compared to 1979 and 1980 and even higher during much of the year.

Scenario 4

These are nightmare scenarios in which inflation does not decline or even accelerates despite a recession as inflationary pressures far exceed the “slack” produced by the Fed. In such a scenario, the Fed may have to adjust interest rates much higher and keep them there much longer than originally expected.

This is probably best captured in 1973-1974 bear market. While inflation appeared to be easily tamed in 1970-71, it came back with a vengeance in 1973-74.

Scenario 5

This is the ultimate wildcard scenario: inflation appears to decline initially, for a year or two or even three, sparking a rally, but then inflation accelerates again and the market is faced with tremendous uncertainty – will the inflation genie ever be put back in the bottle again? This may have been why the 1970s were so terrible for stocks – there wasn’t just one or two bouts of inflation that could have been cured by one shot of restrictive monetary policy. Rather inflation appeared to be an incurable malaise. This scenario is way too far away and the market isn’t pricing it in yet, but it’s worth keeping in mind for down the road.

Where we are at

Right now the market is still pricing in the shock from the higher interest rates. Think of all those valuation models that have been using near 0% rates for 13 years that need to readjust the discount rate using a higher risk-free rate. Several months ago, many commentators were hoping for a swift return to near 0% or low rates by next year. Now these hopes have been shattered and the negativity will take some time to work its way into equity valuations.

I think the best course of action now is not to pre-empt any Fed moves. Any bullishness over “better than expected” inflation readings of any particular month turned out to be a bull trap, for example:

Summary of Recent “Improved” Inflation Readings

Index

Release date of info

Consensus

Actual

Market reaction

Michigan Consumer inflation expectations

Sept 16, 2022

n/a

1 year: 4.6%

5 year: 2.8%

Closed higher

NY Fed inflation expectations

Sep 12, 2022

n/a

1 year: 5.7%

3 year:2.8%

Closed higher by 1%

July CPI

August 10, 2022

Headline: MoM 0.2%

Core: 0.5% MoM

Headline: MoM 0

Core: 0.3% MoM

Closed significantly higher (+3%)

March Core CPI

Apr 12, 2022

MoM 0.5%

MoM 0.3%

Moved higher closed slightly down

Michigan consumer inflation expectations 1-year

Michigan consumer inflation expectations 1-year

Michigan consumer inflation expectations 1-year (tradingeconomics.com)

Michigan consumer inflation expectations 5-year

Michigan consumer inflation expectations 5-year

Michigan consumer inflation expectations 5-year (tradingeconomics.com)

NY Fed inflation expectations

NY Fed inflation expectations

NY Fed inflation expectations (NY Fed)

Nasdaq

Nasdaq (stockcharts.com)

It appears the inflation data improvement in mid-August occurred right before equities took a large dip lower, any buyer based on this alone would have been burnt.

This could be compared with the Fed’s stance during 2020-2021, while despite strong indications the job market was recovering, the Fed maintained its loose monetary policy., because (i) it appeared there were still millions of jobs lost compared to pre-Coronavirus to fill and (ii) there was lingering uncertainty from virus variants even though the vaccine was clearly working .

If we look at the nonfarm payrolls comparison between actual and forecast as shown below, we could see there were many months with beats and many months with misses, for example April 2021 beat of 916k actual vs 647k estimated showed how strongly the economy was recovering from the virus while the next month May 2021 flopped with a 266k actual vs 978k estimated. Month to month figures fluctuated wildly and the Fed largely stayed its course.

US nonfarm payrolls

US nonfarm payrolls (investing.com)

What to buy and what to avoid

Given the above, I believe it will be safe to generally increase exposure to equities only:

  • After there are signs that inflation is completely crushed and the geopolitical tensions that are creating the inflation are completely smothered, or
  • the Fed gives up its restrictive stance, buckling under pressure to lower rates after the economy enters a recession.
  • this high frequency indicator discussed last time may also be a useful reference.

Sector-wise, all sectors are getting hit as part of this revaluation. Defensive sectors or sectors with valuations that are not too high might weather this downturn and come out on top.

  • Again I am most bullish on energy (despite the recent dip along with the rest of the market) and I still don’t think gold and silver are a good idea, given they have had poor performance in past crises.
  • The real risk are sectors that have high valuations now, which might get caught in a downward spiral of lower revenues/earnings and lower valuation multiples:
    • Fast forward a few years and the revenues and earnings might start to recover but the sizzle is gone and the sector is no longer in the limelight.
    • For example, electric vehicles might have maxed out most of their growth in a few years and leading brands now (read Tesla (TSLA)) may no longer be able to present shareholders with the lure of limitless growth anymore, so even if it recovers and continues to grow its revenues or its earnings, the market may never price it the same way a few years later.

The Nifty 50 suffered tremendously losses in 1973-74. Some suffered irreparable losses while others just hovered around for a lost decade:

  • For example, Xerox (XRX) is trading at the same price now (adjusted for splits and dividends) as it was in the 1970s.
  • Whereas McDonald’s (MCD) quickly fell from its peak and languished for a decade before going up over 100 times.

A final observation is that in the 1970s, though stocks as a whole went nowhere:

  • Some stocks weathered the crisis quite well: for example Exxon Mobil (XOM), if you bought it anytime in the 1970s, even if you were unlucky enough to buy it before the 1973-74 crash, you would have eventually made something by the 1980s, at least avoiding substantial capital losses.

ExxonMobil stock price

ExxonMobil stock price (finance.yahoo.com)

  • It was ideal to buy every time there was a sharp dip and a recession. Buying each recessionary crash and selling each optimistic peak would have performed not too poorly in the decade of malaise.

S&P 500 1970s

S&P 500 1970s (multicharts.com)

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