Investor Essentials Daily

2022 spells a new policy for the Fed as the economy continues to reel from Omicron

January 3, 2022

With the new year, it appears the Federal Reserve has itself a New Year’s resolution: retiring the word transitory.

That was the message from Federal Reserve Chairman Jerome Powell when he addressed concerns about inflation to Congress more than a month ago.

Today, in the first Investor Essentials Daily of 2022, we will be going through the Federal Reserve’s new approach to monetary policy for your portfolio. 

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The change in messaging about inflation came soon after the central bank chief was renominated for another four-year stint at the helm of U.S. monetary policy.

In testimony to the U.S. Senate Committee on Banking, Housing and Urban Affairs on November 30 and at the central bank’s last press conference on December 15, Powell appeared much more hawkish.

The Fed chair and his colleagues noted that even with uncertainty around the Omicron variant, the level of price increases had become stronger and broader than they first expected.

This led them to announce they would reduce, or “taper,” their monthly bond purchases and likely raise interest rates three times this year.

In other words, the Fed has said the economy is too hot, and steps need to be taken to cool it down.

So-called Fed watchers and other market experts have taken this hawkish turn to mean 2022 will be the “year of Fed tightening.”

This has naturally led to investors being concerned about the impact of higher interest rates on their portfolios.

Conditions like the labor market or supply chains can change rather quickly. We all remember how fast events transpired in March 2020.

This leaves a constant sense of uncertainty about the future trajectory of interest rates, even if the Fed does a good job of making its intentions clear.

Fortunately, there’s a great way to see just how quickly traders think Powell and company will move with their rate hikes.

Foreign exchange company CME (CME) offers a unique tool that tracks the probabilities of rate hikes or cuts based on market expectations.

Right now, the consensus on the FedWatch Tool is that the Fed will wrap up its bond-buying by March and then start raising interest rates after its May 4 meeting.

Many investors are spooked about their exposure to rising interest rates, although the concerns may not be warranted.

History offers us some powerful lessons about past Fed rate hiking cycles.

The market will likely sell off when the first rate hike is formally announced.

This is because traders are prone to overreact, and they unduly panic that the central bank is ‘taking away the punch bowl’ and ending the party.

Anyone who buys the dip will be richly rewarded.

The reason is that this sort of market reaction to rate hikes is a classic pattern.

The market almost always rallies after the initial pessimism because it becomes clear the Fed isn’t crashing the party but for ensuring it goes on stronger for longer.

Gradual 0.25% increases to interest rates signal a strong and healthy economy – one that no longer needs the stimulus used to recover from the coronavirus pandemic.

Small incremental hikes also show how Powell and his colleagues are comfortable with their strategy. If they were truly concerned about inflation, they would be hinting at much larger hikes.

Large hikes would be problematic for markets. They occur when the Fed pushes the economy into recession by tightening too quickly.

We don’t see any indication of this. The rate hikes penciled in for this year ought to be on your radar, but they shouldn’t be read as a warning of imminent disaster.

Instead, their gradual rate of change should be viewed as a bullish signal on the strength of the American economy.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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