2022 saw the fastest rate hike cycle in decades, bringing turmoil to public and private markets. On an absolute basis, however, interest rates hovering at 4% to 5% are still low by historical standards.
In 2001, The Federal Reserve capitulated when Alan Greenspan cut rates from 6.5% to 1.5% in the face of an economic downturn. The first half of 2001 alone saw interest rates get lowered six times.
Doves within the Fed system have been calling for a similar pause in rate hikes for the past few months but have been outvoted by the hawks. The current dot plot project rates will rise to 4.625% in 2023, far from the rapid turnaround seen in 2001.
Some investors believe the Fed will be forced to capitulate in 2023. Let’s explore why, the odds of it happening, and the market implications.
The dovish argument
In October, San Francisco Fed President Mary Daly said the Fed was considering smaller rate hikes. Daly is joined by the vast majority of economists in a Reuters poll, with 78 of 84 predicting that the Fed will raise rates by just 50 basis points in December, breaking from a chain of four hikes of 75 basis points each.
Moreover, inflation unexpectedly fell below 8% in the same month despite the strong labor market. This has led some to believe that the Fed will have to start reconsidering its rate hike trajectory.
The odds of capitulation
The Secured Overnight Financing Rate (SOFR) is popularly traded and used as a proxy for Fed funds rates.
As one analyst notes, Jun-24 SOFR call spreads with a strike of 98.50 and 98.75 cost 2.5 cents upfront for a maximum payoff of 25 cents, implying a 10% probability of the Fed funds rate is 1.5% in June 2024.
In other words, the market isn’t (yet) pricing in a very high probability of capitulation, but that could change if inflation continues to improve.
The impact on markets
Low-interest rates were a key driver of asset prices in the post-recession era. Even the COVID-19 pandemic didn’t change that, with the Fed pumping in liquidity and keeping rates near zero.
This year’s downturn largely owes to the Fed’s reversal, and a capitulation would likely boost asset prices. Of course, this is predicated on the Fed capitulating, which is far from a sure thing.
The adage “time in the market, not timing the market” still holds. For those who want to take advantage of the inevitable Fed pivot – whether it happens in 2023, 2024, or beyond – the best strategy is to stay invested.
Over 20 years, the stock market has always recovered from corrections and bear markets. And while the Fed’s rate hike cycle may have caused some short-term pain, it’s important to remember that the U.S. economy is still good.
Publicly-traded stocks, however, don’t reflect the whole universe of possible investments. There are far more privately-held companies than there are publicly-traded ones. Not only that, but private equity has historically provided significantly higher returns than the stock market.
Ultimately, whether the Fed capitulates in 2023 or not, there will always be opportunities for those willing to do their homework and take a long-term view.