Hello, Reader.
Last week during a team meeting, our editor asked about our market predictions for the rest of 2022 – especially when it comes to the Fed.
Our general outlook on the market remains neutral: Upside is limited, but we’ve also reached a “lukewarm” temperature where the volatility that struck us for most of 2022 likely won’t come into play.
This is due to several factors, which we mentioned in Friday’s article…
- Jerome Powell and the Federal Reserve System…
- China’s COVID situation…
- And labor and consumption.
Market analysts – including us – “blame” the Fed for our market troubles so often that Powell and company can seem more like a metaphorical scapegoat than an actual influential entity.
It’s such a common occurrence that the phrase “Don’t fight the Fed” has become an axiom every smart investor knows.
So today, let’s talk about the Fed and its importance…
And how by “following the Fed” you can improve your trading habits – and boost your portfolio.
Let’s get started…
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Banks Working Hand-in-Hand With the Fed
Founded by a 1913 congressional bill, the Federal Reserve System works to ensure safety and stability in the U.S. economy. Three key entities comprise the Federal Reserve System, but for the purposes of the stock market, we really only need to focus on the Federal Open Market Committee.
The FOMC sets financial policies for the Federal Reserve System. It influences conditions under which citizens and organizations apply for credit, supervises banks and other financial institutions, and works to contain systemic risks in financial markets.
Financial institutions are required to maintain reserves in federal banks that equal a certain percentage of their deposits. These so-called “reserve requirements” are based on a percentage of total deposits. The interest rate a lending bank can charge another bank to cover its shortfalls is the federal funds rate that we talk so often about.
The Number We Hate to See Go Up
The 12 committee members, including its chair, Jerome Powell, usually meet eight times annually. During those meetings, the FOMC sets the federal funds rate. They consider key economic indicators like unemployment, core inflation, and durable goods reports.
That number also determines the prime rate: the interest-rate lenders – credit card companies, mortgage lenders, and personal and business loan managers — charge their customers with the best credit. Banks generally use the federal funds rate plus 3 percentage points or so to decide the rate, and then increase it based on credit ratings.
Making it more expensive for individuals and businesses to borrow money can hamper growth. While the effects on the general economy may not be seen for a year or more, traders see more immediate effects. The market gets bearish when analysts factor in rate hikes.
A rate hike can mean that consumers and corporations will cut spending. Earnings fall, stock prices drop, and the market may react negatively in anticipation.
Just take a look at tech and other growth stocks!
On the other hand, when a rate cut is anticipated/announced, the market can surge on the expectation of more spending.
Optimism Amid a Bear Market
To tame inflation in 2022, we’ve watched the Fed hike rates as much as 75 basis points at each meeting so far without a single reduction. As a result, a gut-wrenching bear market for 90% of the year has stymied investors.
But there’s reason for optimism as we enter 2023.
First, Powell spoke to the Brooking Institution last week about inflation and the Fed’s economic outlook.
Powell conveyed a more positive message for when the rate hikes may slow. “The time for moderating the pace of rate increases may come as soon as the December meeting,” he said.
Investors don’t like the Fed continuing to raise rates, but higher rates were already priced into the market, which means prices may be artificially low if the hikes start to slow next month.
We’ll keep an eye on the Fed’s moves in December and beyond.
And you should, too.
Sincerely,
John and Wade
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