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When the Fed ended its two-day November policy meeting, it raised the target federal funds rate by three-quarters of a point for a fourth straight time. Its key rate now stands in a range of 3.75% to 4%, the highest in 15 years. It was the central bank’s sixth rate hike since January of this year, which is the fastest pace in decades as it continues its fight to beat back elevated and persistent inflation by slowing economic growth. Investors hoping for the Fed to signal a more dovish tone were disappointed by Federal Reserve Chairman Jerome Powell’s message that rates would stay higher for longer to battle inflation. The year-over-year inflation is currently more than 8%, far above the Fed’s 2% target with few signs yet of cooling off. Core CPI, which strips out the volatile food and energy components accelerated 0.6% in September and was up 6.6% from a year ago, which was the highest pace since August 1982.

However, these rate hikes work with “long and variable lags.” The phrase was coined by famous Nobel-prizewinning American economist Milton Friedman to explain the delayed and uncertain effects of monetary policy in the economy. Raising rates should cause growth to slow down and in turn should lead to lower inflation. However, it can take time for the full impact to be felt; hence Friedman’s idea of a long lag. The variability, meanwhile, refers to the lack of a predictable interval between rate hikes and their  results. As a matter of fact, The International Monetary Fund said last month that interest rate changes have their peak effect on economic growth in about one year and on inflation in three to four years. In the U.K., a 1 percentage-point increase in the policy rate reduces output by 0.6% and inflation by up to 1 percentage point after two to three years, according to a 2016 paper by James Cloyne, then of the Bank of England, and Patrick Hürtgen of Germany’s Bundesbank.

This means that the effects of the global expansionary monetary policies implemented in response to the Covid-19 pandemic induced recession are still being felt. These policies were designed to increase the supply of money and credit to generate economic growth. Meanwhile, the recent consecutive rate hikes have barely cooled either inflation or the labor market at this point.

However, investors and economists are expecting the Federal Reserve’s aggressive interest rate increases to eventually curtail inflation. A widely followed measure of investors’ annual inflation expectations over the next five years, the five-year break-even inflation rate, stood at 2.61% in early November. It reached a record high of 3.59% in March of 2022, and since then it has been coming down gradually, implying investors expect inflation to decline significantly over the next five years. The record low was -2.24% in November of 2008.

Another economic metric indicates an impending economic slump and a looming recession. In recent months, a measure of the money supply called M2 that includes cash, checking deposits, and easily-convertible near money has been falling. In September, the M2 growth rate was 2.56 percent. That’s down from August’s growth rate of 3.82 percent. September’s rate was also well down from September 2021’s rate of 12.87 percent. Recessions tend to be preceded by decelerating money supply. However, the money supply growth rate has a tendency to subsequently start ticking up again before the onset of recession.

It is no surprise that key yield-curve indicators favored by Wall Street have also started to signal that the United States is heading towards an economic slump – perhaps within a year.  In October, 10-year Treasury yields fell below 3-month Treasury yields, creating a so-called yield curve inversion. This signals that investors desire more compensation for buying short-term bonds as compared to longer-term bonds in response to the Fed’s rate hikes and slower anticipated growth. An inversion occurred earlier this year between 10-year and 2-year Treasuries, and in early November, the spread between these yields touched a level not seen since the early 1980s.

The Fed is well aware of the rate-effect lag, and this could create the risk that the Fed might ease off too soon. This is especially true if the hot job market starts to cool and people begin losing their jobs. Recent announcements of some technology companies cutting their workforce, including Twitter and Meta’s upcoming large-scale layoffs, could spill over to other industries. This could prompt a reaction from the Fed to stop increasing rates too early while prices are still rising. Investors may then conclude the Fed isn’t committed to fighting inflation. This would hurt their credibility, especially when they were too slow to begin raising interest rates in the first place.

But lags carry the opposite problem, too. The Fed could instead keep increasing and holding interest rates too high for too long to preserve their credibility, especially if upcoming inflation data continues to run hot as we’ve seen recently, risking potentially a deeper recession than is necessary.

This rate-effect lag is the conundrum facing the Federal Reserve today and let’s hope  the Fed can still achieve a so-called “soft-landing.” Policy mistakes from the Fed in the United States may have more profound ripple effects for the global economy. If you are a student of world affairs, you may know the phrase “when America sneezes, the world catches a cold.” Let’s hope that no one gets a cold before we head into the winter months.

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

The United States entered into a technical recession with the second quarter showing negative growth in real GDP for two consecutive quarters. However, the word “technical” is key. Official recessions are declared by the National Bureau of Economic Research (NBER), which takes a more nuanced perspective. The NBER defines a recession as involving “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” The NBER declares recessions retroactively, meaning that they wait for the data to support their conclusions and then determine whether the U.S. has been in a recession. Economic growth is only one component of a recession; the other major factor is much more relevant and visible to most people: the unemployment rate. Fortunately, unemployment is still low and provides no hint that the U.S. is currently in a recession. This, of course, does not say anything about the future direction of the economy. Unemployment is a lagging indicator (that is, it provides an indication of the previous economic state rather than a prediction of the future state). However, robust employment does indicate that the economy is still relatively healthy despite weak consumer sentiment and strong inflationary pressures.

Although many employers are having trouble finding workers, it is debatable whether the U.S. is in a wage-price spiral. This occurs when rising consumption costs spur workers to demand higher wages resulting in a stagflationary feedback loop. There is no doubt that both inflation and nominal wages are rising, but they are not rising at the same rate. While average hourly wages grew by 5.2% year-over-year in July on a nominal basis, real average hourly wages declined by 3% according to data from the Bureau of Labor Statistics.

This does not imply that a tight labor market and rising wages are irrelevant to inflation, but it does imply that there are other drivers making a greater impact on inflation; primarily supply-chain struggles and energy prices. In July, energy expenditures made up about 9% of CPI, with energy prices rising 32.9% from a year prior. The good news is that energy prices have started to decline over the short-term. Gasoline prices, for example, declined 7.7% from June to July. This led to a welcome slowdown in inflation with prices up in July only 8.5% year-over-year as compared to 9.1% for June. It will take more than one month to reign-in inflation, however, especially as core CPI, which excludes volatile food and energy costs, barely budged in July compared to a month prior (albeit after declining more quickly from March to June than the all items CPI). The Fed will likely have to continue being aggressive in order to maintain credibility in its ability and willingness to fight inflation.

The tight labor market gives the Fed some room to maneuver and still maintain the hope of a soft landing, at least for now. Focusing all attention on the labor market would indicate that the U.S. is not even close to a recession at the moment. One relevant indicator to examine is the Sahm Rule, created by economist Claudia Sahm, which signals a recession as soon as the three-month moving average of the unemployment rate rises by 0.5% relative to its 12-month low. This is meant to be a real-time signal of recession rather than a retroactive declaration, as with the NBER. As one would expect, this is currently well below the 0.5% threshold that would signal recession.

As previously mentioned, unemployment is a lagging indicator, and does not give a strong signal about the future health of the economy. To try to predict future economic conditions, one may do better to focus on leading indicators. One of the best leading indicators is the stock market. This is unfortunate for investors who may try to use recessions as a trading signal. Often by the time the economy is in a recession, much of the damage in stocks has already been done. The S&P 500 Index entered bear market territory earlier this year but has recovered some of the loss. Whether the market is in a true recovery or “bear market rally” remains to be seen, but the heightened volatility does suggest that some investors are wary of an economic downturn. Further evidence of recession fears comes from the U.S. Treasury yield curve. This classic recession indicator is said to forebode recession when it is inverted, or long-term Treasury yields fall below short-term yields as investors price in the anticipation of rate hikes from the Fed (short-term rates are more sensitive to changes in the Federal Funds Rate than long-term rates are[1]). The yield curve is in the process of flattening and has already inverted when comparing the long-term 10-year yield vs. the short-term 2-year yield. Some argue that a better indicator is the spread between the 10-year and 3-month yield, which has not yet inverted, but has been on the verge of inversion since late July. There are other leading indicators as well, which are often combined together into a single index to provide a better signal; but, of course, none of these indicators are perfect predictors.

There is still work to do before the Fed turns dovish again, and investors should not expect a technical recession by way of declining GDP growth to turn the Fed’s attention away from inflation. Many blame the Fed, at least partially, for high inflation due to the vast amount of monetary stimulus injected into the economy in response to the covid-19 pandemic. During the pandemic, the Fed made clear that their priority was very understandably lowering unemployment. As the pandemic dragged on into 2021 and unemployment began to fall while inflation started to creep up, the Fed still was focused on unemployment while dismissing inflation as transitory. Then, inflation started to dominate the headlines and the Fed switched gears into inflation-fighting mode. The Fed has been somewhat fortunate in that it has been able to focus most of its energies at one time on either unemployment or inflation; not both. Although the Fed must bring inflation down, Jerome Powell and company must be careful not to lose total sight of the labor market. As rates continue to rise, the Fed’s already difficult task could become more difficult. The Fed will have to walk a tightrope: a wrong step in one direction and inflation will continue to entrench itself in the economy; a wrong step in the other, and workers could begin to lose jobs at a higher rate. If the latter happens, the U.S. could experience a real recession. But that has not happened yet, and there is still a possibility that the Fed can walk the tightrope to the other side without stumbling.

[1] Note that this refers specifically to yields rather than prices. Bond prices are more sensitive to interest rate changes at the long end of the curve.

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.

The majority of investors are well-informed of the headwinds facing financial markets, primarily elevated inflation in combination with tightening monetary conditions. Most have felt a damaging impact on their investments, especially since many of the successful strategies utilized in bull markets are now ineffective. Younger investors have never experienced such a substantial rising rate environment. On May 4^th, the Fed implemented a half-percentage-point rate increase, which is the largest since 2000, and they are doing so at the fastest pace in over three decades. If they continue down this direction with additional half-point increases, rather than the typical quarter-point increase, this would be the most aggressive pace for policy-tightening since the 1980s. Many criticize the Fed for believing that inflation was transitory and for having a delayed response in combatting it. The most well-known tool in the Fed’s arsenal to fight inflation is interest rates. The short-term interest rate, also known as the Fed Funds rate, is directly controlled by the Federal Reserve. When the Fed raises this rate, it becomes more expensive to borrow money, which results in less investment and consumer spending. The current inflationary environment is a result of aggregate demand exceeding supply, so by raising interest rates, the Fed is attempting to push down this demand to stabilize prices. However, it is of course not that simple. Price stability is only one half of the Fed’s dual mandate; the other half is to promote maximum sustainable employment. If the Fed does not handle the rate hikes correctly, the economy could slow down much too quickly. Workers could lose their jobs, and the unemployment rate may increase; it could possibly even result in a recession. Therefore, it is important to be informed on current investor sentiment and involvement in the market as well as how certain investments have historically performed in rising rate environments.

Recently, there was an inflow of investors in the market who have jumped in on “buying the dip.” Many investments that performed very well before this year’s selloff, such as the ARK Innovation ETF from Cathie Wood, have now plummeted. Despite this, investors have remained resilient and asset flows indicate that the general strategy of investors during this interest rate-hike environment is drastically different than it has been in the past. Historically, when the S&P500 has suffered such a decline like what is happening now, investors sold nearly $10 billion in the first twelve weeks after the market peak. Now, on the contrary, investors recently invested an additional $114 billion as the S&P500 was dropping into bear market territory. This March, a record for the largest monthly sum was reached when there was an inflow of $28 billion in exchange traded funds and U.S. stocks. Following that, investors hit a one-day record when they invested about $2.6 billion in the same asset classes.¹ There is an evident shift in investor sentiment compared to the past, and a reason for this relates to the financial crisis of 2008.

Unfortunately, investors that sold out of panic in the crisis later regretted their decision. Not only did they lock in their losses, but afterwards, there was an extended bull market where the S&P500 soared nearly 400%. This experience has left modern-day investors more optimistic in holding onto their assets for the long-term. Although they are confident, some investors’ positivity is beginning to deteriorate. The current selloff is becoming prolonged compared to the most recent bear market in 2020, which only existed for roughly 23 trading days. Many individuals who “bought the dip” this time continue to suffer losses. It is impossible to know how far the dip will go, and this leaves investors who have cash on the sidelines with the complex decision of when to wade into the market.

It is important to know how certain asset classes have performed in the past when interest rates were on the rise (keeping in mind that past results are not a guarantee of the future). Additionally, there is no rulebook detailing what to do when interest rates rise, and there is not a single strategy that will work for every investor. If you have created a sound financial plan you are comfortable with for the long-haul, then you should stick with it and may need to only make minor changes to weather the current storm. Generally, when interest rates rise, fixed income investments will decline in value; a common principle is that bond prices and interest rates tend to move in opposite directions. Bonds’ sensitivity to interest rate changes is measured by duration. A higher duration implies higher interest rate risk. For example, longer-maturity bonds will be more sensitive to movements in interest rates compared to shorter-maturity bonds, all else equal. If a fixed income strategy has a shorter duration, then it has less exposure to rising rates. In regard to Treasury bonds, many consider these to be a safe-haven due to their lack of default risk, which is the risk that the borrower will be unable to make the required payments on principal and interest to the lender. Aside from interest rate risk, the other primary risk to Treasury bonds is inflation. Higher inflation erodes purchasing power and therefore makes fixed coupon and principal payments less valuable to the bond owner. Corporate bonds have these risks as well but are considered riskier than Treasury bonds since they also have default risk. Unintuitively, however, corporate bonds have typically performed better during times of interest rate increases compared to Treasury bonds. This is due to credit spreads. Credit spreads are the differences in yields between corporate and Treasury bonds. Credit spreads measure how much extra return an investor requires for accepting default risk. When credit spreads shrink, corporate bonds benefit because investors are more willing to take on default risk. Generally, the economy is still strong when the Fed raises rates, and credit spreads typically narrow when the economy is strong. Hence, corporate bonds have performed better in these times historically.

There are alternative fixed-income options to traditional, fixed-coupon bonds as well. For example, interest rate hedged bond ETFs aim to eliminate any form of interest rate risk by incorporating hedges specifically targeted at rising rates. However, these limit profit opportunity when rates fall. Floating rate investment grade bonds also have very little exposure to movements in rates, so a substantial portion of interest rate risk is eliminated during rising rate environments. TIPS, or Treasury Inflation Protected Securities, have been in the spotlight recently due to current inflation levels. One caveat is that these are meant to hedge against inflation expectations, not against realized inflation, and they do not protect against changes in real interest rates. However, TIPS outperformed Treasuries when the Fed increased rates in the past.²

Investors should not pick one asset class for their portfolio. Rather, they should take a multi-asset approach. Shifting away from fixed-income strategies, equities do not necessarily always struggle in times of rising interest rates. Historically, when rates rise, the financial, industrials, materials, and energy sectors have been top performers.² Value stocks can also perform well compared to growth stocks in rising rate environments. The former is composed of companies with stock prices near or below the intrinsic value of the business whereas the latter relies on estimates of future cash flows to derive value. However, as interest rates rise, future cash flows become less valuable in present value terms, so investors have more appetite for current, stable cash flows like those found in value stocks.

Of course, every rate hiking cycle is different, and asset classes that outperform in one environment may not continue to do so in the future. Each investment has its own specific risks, and there are other factors to consider in every decision rather than just rising rates. Speak with Passage Global Capital Management to learn about the risks of investing in a rising interest rate environment and how they can be properly managed.

¹Banerji, Gunjan and McCabe, Caitlin. “Buy the Dip Believers Are Tested by Market’s Downward Slide.” Wall Street Journal. May 10, 2022.

² ”A Playbook for Rising Interest Rates.” ProShares. 2022.

The views expressed represent the opinion of Passage Global Capital Management, LLC. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute as investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. While Passage Global Capital Management, LLC believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Passage Global Capital Management, LLC’s views as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumption that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements.