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The Federal Reserve appears set to raise interest rates at its Jan. 31- Feb. 1 meeting after hiking rates seven times in 2022. The nation’s central bank is expected to lift the benchmark Fed funds rate by 0.25 percentage point, according to the CME FedWatch tool.
It’s likely not the last increase for this economic cycle, either. The odds are high that the Fed will raise rates at its March 2023 meeting as it attempts to get inflation – which hit 6.5 percent in December 2022, compared to a year earlier – under control.
Higher rates have been playing out on stocks, cryptocurrency and commodities such as oil over the last year. But what can investors expect from here and how long will the rising-rate environment impact markets?
Higher rates and recession fears losing effect on the market
While the Fed has already raised rates seven times during this tightening cycle, it’s easy to spot when markets really sat up and took notice that the central bank wasn’t kidding that it was about to recalibrate monetary policy. It was November 2021 when cryptocurrency and many of the riskiest stocks peaked.
“The stock market will never not worry about future interest rates,” says Steve Azoury, head of Azoury Financial in Troy, Michigan. “The cost of borrowing impacts all areas of investing, purchasing and savings. Just the anticipation of what may happen is enough to cause a stock market reaction.”
But still-rising rates seem to be frightening investors less these days, as they anticipate the Fed to stand pat in the near future.
“I think markets are far less anxious about interest rate hikes now than in Q3 and Q4 2022,” says Dan Raju, CEO of Tradier, a brokerage platform. “With the better-than-expected recent inflation numbers, the Fed and investors feel like they have some control on inflation. It seems now everyone sees a path to an eventual holding off of rate hikes.”
While major stock indexes such as the Standard & Poors 500 spent most of 2022 in a funk, equities seem to have found a floor since October. They’ve fared well to start the year, too, with the S&P 500 up more than 4 percent. The Nasdaq Composite has climbed more than 8 percent to kick off the new year.
But what about the highly expected recession? The market’s recent relative strength suggests that investors may be more optimistic – or at least, less pessimistic – than they were in 2022.
Whether a recession happens and its potential severity are major uncertainties now, says Brian Spinelli, co-chief investment officer at wealth advisor Halbert Hargrove in Long Beach, California. “Stocks are forward-looking and our best estimate is a mild recession has been anticipated in current prices. If we end up in a deeper recession, that is likely not priced into markets today.”
So there may yet be plenty of room for markets to fall further if the economy worsens significantly.
“When the Fed introduced restrictive monetary policies by increasing rates in 2022, this caused equity markets and cryptocurrencies to appropriately decline in valuation,” says Octavio Sandoval, director of investments at Illumen Capital.
Unprofitable high-growth stocks had a quite rough 2022, and while prices may have firmed up recently, that doesn’t mean these stocks are anywhere close to their prior highs. For example, software stocks such as Cloudflare and Datadog are worth less than half their all-time highs.
When it comes to crypto, Bitcoin is still down more than 65 percent from its all-time high set in November 2021. The second-largest cryptocurrency Ethereum has seen a similar drop over the same period as riskier assets have struggled.
Will rising rates and inflation continue to derail stocks?
Stocks and cryptocurrency have endured notable volatility as investors have factored in rising rates. But what’s in store for the next six months, with many rate hikes already completed and perhaps a few more still in the cards?
“Cost of capital for companies is going up, there are arguably tighter lending conditions for consumers and there is still uncertainty about the level at which the Fed pauses its rate hikes to try and tame inflation,” says Spinelli.
With less money sloshing about in financial markets, that’s a net minus for investments as a whole, but investors have a notable habit of looking beyond today’s news.
“The markets appear to be pricing in a Fed pause in Q1 2023,” says Spinelli. “While the Fed is saying they are going to continue raising rates to make sure inflation is tamed, the markets are second guessing [that stance] at this point.”
Market watchers are still divided as to whether the Fed will do too much or too little and whether that’s already priced into stocks. This uncertainty itself drives volatility in the markets. In the meantime, markets continue to re-adjust to the Fed’s aggressive rate hikes with the hopes that the central bank gets a better handle on inflation and reins it in. That looks to be the case after the last few months of inflation data, however, and markets have become less dour.
The bellwether 10-year Treasury, now offering a 3.5 percent yield, is off its 52-week high of 4.33 percent set in October. The decline suggests investors are increasingly expecting the economy to slow in the near term, relative to their expectations of four months ago.
Now, with short-term rates well above longer-term rates – a so-called yield-curve inversion – many market watchers are expecting a recession to occur in 2023. A recession would likely push the stock market even lower until investors can begin to gauge the length and depth of any upcoming economic downturn. But that may not stop intermittent bear market rallies.
“Retail investors feel confident that the Fed will announce a much smaller rate hike this month and I expect the tech sector to see a bounce after the upcoming meeting,” says Raju. “This drama is not over yet.”
How higher interest rates have affected crypto and commodities markets
Two other major asset classes have had varied responses in the face of higher rates. While cryptocurrency prices have plummeted along with other risky assets, many commodities spiked higher in early 2022, including oil, but many of those moves proved short-lived. With rising rates expected to slow or stop, both oil and crypto seem to have found a floor.
Cryptocurrency has often been touted as a cure-all for what ails you, whether that’s inflation, low interest rates, lack of purchasing power, devaluation of the dollar and so on. Those positives were easy to believe in as long as crypto was rising, seemingly regardless of other assets.
“Higher rates generally lower appetite for riskier investments and that is likely one of the causes for a significant pullback in digital asset prices over the last year,” says Spinelli.
Indeed, cryptocurrencies responded to reduced liquidity as did other risky assets, by falling when the Fed announced in November 2021 its intention to raise rates and then throughout 2022 as the Fed aggressively followed through. On top of that, high-profile blow-ups of individual cryptocurrencies and exchanges such as FTX have hammered traders’ confidence in these virtual assets.
“The future of crypto in 2023 is going to be driven by how much appetite for risk exists among the investor community,” says Raju. “Right now, the market does not seem to have that appetite.”
Many commodities have been well off their recent highs, as fewer supply constraints and higher interest rates work to take them down a few notches. But the expectation that the Fed will soon be done raising rates has recently helped keep oil from falling below about $70 a barrel.
For example, the price of oil had been in a steady downtrend to around $74 per barrel after peaking at around $123 in June. But oil hit a recent bottom in early December at around $70.
How should rising rates impact your investing strategy?
Rising rates, high inflation and uncertainty – all create a stew of volatility for investors. With so much volatility, investors may want to tread cautiously.
However, the best way for most investors to approach this type of market is to stick to the long-term game plan. For many, the long-term plan means continuing to invest regularly in a diversified portfolio of stocks or bonds and mostly disregarding the noise around the world. For others, the game plan may involve buying and holding well-diversified index funds. Either way, don’t let emotions get in the way of an effective long-term investing plan.
While short-term traders may be sweating rising rates and trying to time a recession, it’s vital to keep things in perspective. Instead of trying to find the right time to sell, buy-and-hold investors can use the market’s volatility to their advantage and then try to find the right time to add more.
“For long-term investors, the pullbacks represent attractive buying opportunities,” says Greg McBride, CFA, Bankrate chief financial analyst.
Downturns can be an attractive time to add to your portfolio at discounted prices. As investing legend Warren Buffett once said, “You pay a very high price in the stock market for a cheery consensus.” That is, stocks are cheaper when few agree that they’re an attractive investment.
Interest rates rose fast in 2022, and the big question right now is just how high they will go in 2023. Those investors with a long-term investing horizon may view it as an ideal time to pick up some quality investments at bargain prices.
And if stock valuations continue to plummet? Buffett has some wisdom for that situation, too: “Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.”