The Fed plans to tighten next year. Fed decision-makers now anticipate between one and four rate hikes in 2022. With most decision makers thinking we’ll see 3 hikes in 2022 given high inflation and a relatively tight labor market.
The bond market takes a similar view according to the CME’s FedWatch Tool. However, the bond market sees a slightly broader dispersion of outcomes, suggesting five hikes are an outside possibility, but again with three hikes in rates the most likely outcome.
The impact of rate hikes on markets is complex. First off, the Fed expect to raise rates in part because the economic environment is good. Yes, current high inflation is a worry. However, the environment of strong consumer demand and low employment sets a positive backdrop for the economy. Against that, the Fed feels comfortable raising rates, and such a positive economic climate is often good for the stock market. However, the Fed raising rates all else equal is a drag, making access to money harder. Which of the two forces wins out? The benefit of strong economy or the dampening impact of higher rates?
Invest With The Fed
In their book, Invest With The Fed, Robert Johnson and his co-authors find Fed policy matters to markets and the act of the Fed raising rates can offset a favorable economic environment. Stock and bond returns can be lower in restrictive monetary policy environments as the Fed raises rates. This implies that the impact of the Fed upping rates wins out and even though the economy may good. Historically stocks fare a little worse because of increasing rates, though returns often remain positive.
Stock returns over recent years have been very high relative to history, so some moderation in returns should not surprise us, especially if rates do go up.
Furthermore, it also pays to examine the composition of your portfolio. Commodities, real estate and defensive stocks have historically fared better when rates are increased based on broad historical trends.
That said, the Fed has not materially raised rates yet. They just plan to. Still, if they do their actions may limit the sort of exuberance that we’ve seen in financial markets in 2021. Of course, a lot can happen between the Fed’s forecast and the reality, but the prospects for stocks may have become a little dimmer in 2022.