AFMC - What Happens When The Fed Stops Raising Interest Rates

2023-04-06 08:22:47 ET

Summary

• Weaker economic data keeps raising recession fears.
• Yet slower growth is needed to tame inflation and end the Fed's rate-hike cycle.
• The S&P 500 has performed well when the Fed stops raising rates in data dating back to 1990.

While inflation was the primary concern for the consensus of investors, any indication that the rate of economic growth was slowing was welcomed by markets. In other words, bad news was good news. It meant that monetary policy tightening was having its desired impact, and that the disinflationary trend that started last June would likely continue. After last week’s better-than-expected inflation report from the personal consumption expenditures ((PCE)) price index, investors are shifting focus to waning growth. Bears on Wall Street who seem to be looking for new reasons to justify their narrative are warning investors that signs of economic sluggishness indicate a recession is on deck for the second half of this year. Unsurprisingly, this will be the new wall of worry risk asset prices must climb as we move forward.

Yesterday’s economic reports would have been welcomed news a month ago. The ADP employment report showed 145,000 private payrolls were added in March compared to an upwardly revised 261,000 in February. As has been the trend, the leisure and hospitality sector led in job gains. Wage growth slowed from 7.2% to 6.9% for job holders. This is what the Fed and those who have been myopically focused on an elevated rate of inflation should want to see. There is nothing in these numbers to suggest a recession is on the horizon. In fact, 145,000 new jobs per month is more than sufficient to absorb the population growth, which Chairman Powell estimated to be just 100,000 in December of last year.

The Institute for Supply Management’s purchasing managers index ((PMI)) for the service sector fell well below expectations for a reading of 54.4 in March to just 51.2. Still, that doesn’t mean the economy is in recession or on track for one. Any number above 50 indicates growth, and the latest reading signifies an economy that is growing below trend but still growing. We need to see a deceleration in the rate of growth for services if we are to see a cooling in price pressures. To that point, the index for input costs fell sharply as well to the lowest level since July 2020.

The upside from these reports, as well as upcoming ones that reflect slower growth, is that they should force the Fed to pause at its next meeting in May. That will allow more time for the rate of inflation to recede further, which ultimately should convince the Fed that its rate-hike campaign ended with the last increase in March. We should already be at the terminal rate. What happens when the Fed stops raising short-term interest rates?

The news is good on this front, as the stock market has tended to rally when we look at the past four distinct rate hike cycles dating back to 1990. According to DataTrek, the S&P 500 was higher on average one month (3.3%), three months (8%), and one year (17.5%) after the last hike during this time frame. The only period following a final rate increase when the S&P 500 saw a decline was in May of 2000. The index was higher one month (1.8%) and three months (2.2%) later, but was down 14% after one year. I think this precedent provides another tailwind for bulls in 2023.

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