Here’s Why Investors Have Mixed Feelings About the Fed’s Latest Rate Hike

The Federal Open Markets Committee (FOMC), the monetary policy arm of the Federal Reserve, on Wednesday raised the federal funds rate by a quarter of a percentage point to a target range of 4.75% to 5%. Although this was the more aggressive of the two most likely outcomes from the Fed meeting, the S&P 500 rose briefly after the move was announced – only to fall from there to end the day down 1.65%.

Here’s a look at why the market reacted the way it did and what could happen to future interest rates.

Why did investors have mixed feelings after the rate hike?

Over the past year, the Fed has made a series of aggressive rate hikes to try to curb inflation and appears to believe more rate hikes are needed. All other things being equal, higher interest rates are generally a negative catalyst for stocks, so it’s not surprising that the market ended up falling.

However, there are some potential catalysts that may have led to the initial positive reaction to a higher federal funds rate. For one, for the first time in the current rate hike cycle, the Fed has indicated that we may be near the top. Earlier versions of the statement that accompanied the FOMC’s decision used the phrase “continued hikes” when discussing the outlook, but this removed that language, instead saying that “additional policy tightening may be appropriate” to curb inflation bring the target level of 2%. Also, the Fed left its “final rate” unchanged from its December estimate at 5.1%, implying only one more rate hike. Although this is identical to the previous forecast, just a few weeks ago Fed Chair Jerome Powell said the FOMC may have to hike rates more than previously expected.

In addition, the Fed clarifies that it expects interest rates to fall in both 2024 and 2025, with a median forecast of 3.1% through the end of 2025, with inflation approaching the 2% target at that point. For now, the FOMC said in a statement that unemployment remains low and inflation high, justifying the recent rate hike.

On the other hand, given the ongoing banking crisis, investors could see this rate hike as an unnecessarily aggressive move. The FOMC conceded that recent bank failures and ongoing uncertainty in the industry are likely to tighten credit conditions, slow hiring and put pressure on inflation. In short, these are the targets of the Fed’s rate hikes, leaving investors wondering why the Fed decided to continue its tightening cycle.

Where will interest rates go from here?

Another interesting development is that the FOMC’s rate forecasts for the future and the market’s expectations are two very different things, and that uncertainty probably doesn’t help (markets do not like uncertainty).

FOMC sees rates at 5.1% at the end of 2023, suggesting another 25 basis point rise before a pause. The committee, as noted, sees a drop to 4.1% by the end of next year and 3.1% by the end of next year.

On the other hand, according to the CME’s FedWatch tool, the stock market expects the federal funds rate to rise fall 50 basis points from current levels this year, and that the most likely outcome by the end of 2024 is a 3% to 3.25% range, which the Fed won’t achieve until the end of 2025.

In short, there’s quite a bit of a disconnect between what the Fed is forecasting and what investors think rates will actually rise. But whatever happens in the future, investors seem to be taking the outcome of this week’s FOMC meeting as a sign that we are at or near the peak of the rate hike cycle, although the market appears to be hoping for a pause in rate hikes has or a softer tone from the committee.