Would a bear market affect Fed interest rate hikes?
The stock market is often seen as a leading indicator of the economy, and it is widely believed that the Fed will react to what is happening in the markets. Currently, we are in a situation where the market consensus is that inflation is high and persistent. While the high is evident from the CPI statistics, which are indeed concerning, the persistence is more of a question mark, but that’s for later. Nevertheless, the markets are anxious about the inflation situation, and it is clear that the rate hikes, already explicitly promised by the Fed, are priced in by the market, where the promised rate hikes are aimed at combating inflation.
We believe that a bear market in the wake of immediate rate hikes is not particularly likely to affect Fed decision-making, since inflation is a major concern for the economy and the market. In fact, if we enter a difficult period due to inflation fears, rate hikes could even come sooner and with more conviction than expected. However, with built-in rate hikes, a bear market following rate hikes is unlikely. What worries us most is what will happen if inflation persists after rate hikes. We think this is entirely possible, and the markets could react very badly to this news, as it should. If that happens, the Fed hikes are likely to reverse. Overall, inflation remains at the center of the discussion, and our belief in its dynamics is very different from the market consensus, which could create a buying opportunity.
What is the impact of Fed interest rates on the market?
the Fed interest rates, or the federal funds rate, is one of the most fundamental rates in the economy because it is dictated by the Federal Reserve, which controls the money supply and refers to the rate at which the funds’ key day-to-day liquidity between depository institutions owned at The Fed is borrowed from and lent to. The rate of these short-term overnight loans eventually spreads out to the rest of the economy for loans of longer duration and with higher credit risk that are priced above the basic federal funds rate. Thus, when the federal funds rate is raised, interest rates experience a general increase and credit becomes less in demand and therefore less available. This is also spreading due to the mechanics of debt, and there is a reduction in the availability of credit which reduces household and industry spending.
Would a bear market affect Fed rate hikes?
There have been times in the past when the market seemed to hold the Fed hostage, when its temper tantrums “dictated” monetary policy. It was such a widely recognized phenomenon that a term was coined for it, known as “Sale of Greenspan‘. Although there is a political discussion here, what can certainly be said is that the stock market, being the rather efficient opinion machine that it is, is a leading indicator of the economy, and the Fed is undoubtedly paying some attention to it. So, what would be the interactions between the markets and a rise in rates in this case?
Fed rate hikes are almost certain to happen at least initially, as the language has been fairly unequivocal at this point and focused on fighting inflation. A degree of market jitters are to be expected as rates actually rise, especially with all the leverage introduced into the economy following the initial pandemic outbreak. However, in this case, rate hikes are already priced in to some degree, so a negative impact on markets beyond that point is not guaranteed. We don’t believe rate hikes will actually cause a bear market and are therefore unlikely to have an immediate impact on the decision to raise rates.
Is inflation transitory?
Our concern is whether rate hikes, which honestly might even be appreciated by the markets given that inflation is the real boogeyman, will actually help reduce inflation. Our belief is that over the longer term, despite the Fed’s withdrawal of this language, inflation is transitory. In the medium term, however, that is not the case, and that is because inflation comes from physical and not immediately changeable constraints on the supply side, and not so much on the demand side. Our non-consensus view is that COVID-19 has actually had a positive impact on the productivity of our economies by accelerating and proliferating digitalization, hence even disinflationary pressure. Moreover, it permanently shifted demand from services to goods, for which our production capacity was not prepared. Planned closures and maintenance in anticipation of greater declines or at least uncertainty about the economy in 2020 have created drawdowns on stocks. In addition, capacity had to increase to meet higher levels of demand for goods. We are seeing an increase in production facilities across the industry, with an example among our holdings being Suzano (NYSE:SUZ), a major pulp producer that is increasing its production by 20% with a project lasting about three years. Other companies like Costamare (NYSE: CMRE) in maritime transport, are increasing the size of their fleet. Besides very clear bottlenecks in logistics, with submerged ports, and generally tight commodity environments, we are seeing substantial inflation. This includes oil where OPEC maintains discipline due to pandemic-related reduced mobility.
We believe that inflation is transitory, in the sense that it will take about 2-3 years before all shortages and rising commodity prices are normalized by increases in production capacity, which will take about as long, if not longer, again due to shortages and high commodity prices. Until then, we believe that interest rates will not have such a significant impact on inflation, as a lot comes from the supply side.
If our non-consensual view turns out to be true, the markets could become very disrupted. While an initial bear market might not start with rate hikes, the failure of rate hikes to fight inflation could create serious concerns about the economy, inflation being a very pernicious force. . This could trigger a bear market, or even deleveraging, since nominal rates will remain quite high if inflation persists and corporate fundamentals are likely to be affected for all players downstream in the supply chains. At this point, further rate hikes, or at least maintaining higher fed funds rates, may no longer be desired, and with markets being an important measure for the economy, rate hikes may be reversed. So while an immediate bear market on the initial rate hikes seems unlikely, and therefore an effect on Fed policy unlikely, what happens over the 6-12 month period is more uncertain. and could include serious market concerns about the economy possibly reversing. rates.
We continue to believe that the rate of inflation is supply-driven to a large extent, so we continue to position ourselves in commodity-related positions like SUZ, or companies where cost bases are fixed and products are needed with pricing power. Therefore, we are also quite optimistic about the economy of the developed world. But we believe that a bear market could be looming in connection with the appearance of galloping inflation. With our non-consensus view, we would then see a buying opportunity.