The Rate-Hike Playbook: Preparing for Rising Rates and High Inflation

Lower-for-longer is no longer. After more than a decade of suppressed interest rates, the U.S. Federal Reserve is rapidly pivoting to a more hawkish outlook, closing an era of cheap and easy money.

Expectations for a string of interest-rate hikes by the Fed over the coming year have sent markets into a whirl. Based on Fed Fund Futures, markets anticipate that rates will reach 2.5% by February 2023. And that may not be hawkish enough, with one voting member calling for rates to be as high as 3.5% by the year’s end.

For retail investors in Asia – many of whom only began trading during the Covid-19 pandemic – this is unfamiliar territory. The world has grown so accustomed to an environment of low rates and low inflation that some forecasters suggested it had become a permanent state. But with consumer prices also soaring at a pace not seen in 40 years, there is now a widespread sense of disorientation.

“As a reminder, between February 1994 and February 1995, the Fed lifted interest rates from 3.25% to 6%...in response to a strong economy and an inflation rate that was only 2.5%, compared with 7.9% currently,” said Tony Sycamore, a Senior Market Analyst at City Index.

How should investors respond to this rapidly evolving environment? What asset classes will be affected? And do retail traders in Asia need to worry?

“As the Fed sets the price of money and levels of liquidity within the financial system, it’s a big deal when their policy changes,” explains Matt Simpson, another Senior Market Analyst at City Index. “Liquidity – or lack of it – can make or break a market cycle, and the Fed directly controls it. Their policies therefore directly impact the strength and direction of global trends across all asset classes.”

So, whether invested primarily in U.S. stocks, currencies, Asian bonds, or commodities, all investors need to pay attention to coming developments and adjust their strategies accordingly.

The Outlook for Stocks

There is a common perception that interest-rate rises are negative for the stock market. Indeed, in the period immediately following the Fed’s pivot to inflation control priorities this year, the S&P 500 dropped, and the benchmark 10-year Treasury yield rose.

Equity markets are typically unstable during periods of transition from economic recovery to expansion. The current environment of geopolitical turmoil, high inflation and the unwinding of pandemic stimulus are negative for stocks. Furthermore, the Fed's balance sheet and S&P 500 multiples have had a positive relationship since the financial crisis, suggesting the pending slim-down could depress market valuations.

On the other hand, earnings growth is likely to support stocks. Bloomberg Intelligence modelling suggests that the S&P 500 is fairly valued at around a 20.5x, and the Russell 2000 will remain stuck below record highs for the year.

The net effect could be 12 months of volatility, with markets ending the period roughly where they started.

“If you stand back and look at the big picture, it’s not always the case that rate hikes are bad for stocks,” said Simpson. “It’s true that the stock market initially reacts to the downside over a period of weeks or months, but by the cycle’s peak, markets are generally higher.

“It also depends on why the Fed is hiking. If the economy gets too hot, they can hike to cool growth, but now they’re being forced to hike because of runaway inflation caused by supply chain disruptions, which itself is a drag on growth. So there is a concern that the Fed will need to hike aggressively and maintain rates at a relatively high level for longer than they wish.”

So how can investors re-position themselves to capitalize on these trends? On a strategic level, it makes sense for traders to ring-fence their equity portfolios against volatility, using protective tools such as CFDs with stops/limits, or options, to minimize the potential impact of sudden surprise swings.

Investors can also look at sectors that have historically thrived during periods of interest-rate increases and higher inflation.

“Financials tend to do well, as higher rates often mean wider margins, along with industrials and consumer discretionary companies,” Simpson said. “But it’s worth bearing in mind that not all cycles are equal. While the Financial sector averaged a 27% gain over the past two hiking cycles, the sector fell as much as 25% when the Nasdaq bubble burst whilst the Fed were still hiking.”

The Outlook for the U.S. Dollar

War, and a prevailing sense of geopolitical uncertainty, has so far clouded the currency response to impending rate hikes. That impact is expected to wane steadily into the second quarter of 2022 and beyond, and the dominant theme will once again be runaway inflation and the implications of interest-rate normalization.

In the lead-up to the expected rate increases, the U.S. Dollar has dominated, and the likely persistence of instability means it still makes sense for investors to maintain some exposure for diversification purposes. But Fed hawkishness may no longer be sufficient to sustain U.S. Dollar strength, and many analysts see other currencies moving to the fore as the year unfolds.

“Once the rate-hike hype dies down and other central banks are forced to play catch-up, we’d back commodity currencies such as the AUD, CAD and NZD to outperform the dollar as we head into the second half of the year,” Simpson said.

“And while the USD/JPY has ripped higher at an epic rate, there will come a point where Japan’s central authorities will have to intervene (at least verbally) to stabilize their currency.”

Meanwhile, thoughts of the European Central Bank adjusting higher are contributing to recent euro resilience, and the prospect of an ECB move away from negative rates could add to euro upside, especially if this comes with fiscal support and avoids a recession.

According to Bloomberg Intelligence, Asian currencies are also poised to consolidate against the dollar in the second quarter. Several Fed meetings may pass before markets are convinced that the Fed doesn’t want to upset the rate-hike cycle it has priced in, removing a tailwind for dollar weakness.

Markets across all asset classes and geographies, then, will be keeping a close eye on the Fed’s direction over the course of the year, and retail investors in Asia would be wise to follow suit.

“As the Fed seek to control inflation through monetary policy, investors should keep a close eye on Consumer Price Inflation (CPI) reports,” Simpson said. “The Fed meetings provide a roadmap of where the Fed think they are and hope to be, but to keep ahead of Fed policy, investors need to monitor leading indicators such as Purchasing Managers Index (PMI) reports, as they provide a forward look at growth potential and inflationary pressures. Investors can then use inflation and Fed meetings as confirmation of their analysis seen from PMIs.”