US Federal Reserve Monetary Meeting and its Impact

The US Federal Reserve has indicated that they could increase interest rates in March, putting an end to the pandemic-driven easy monetary policy witnessed so far. We try to decode the major highlights from yesterday’s meeting, and the potential impact on equity and debt markets. 

Highlights from the meet

Fed’s commentary on inflation: Inflation has reached a 40-year high in the US. . Fed Chairman, Jerome Powell, said that the inflation is not going back to the pre-pandemic level anytime soon. Hence, the rise in prices could accelerate. 

He also highlighted there is a fear of inflation increasing even higher. However, the chairman mentioned they are in a position to address all of the plausible outcomes. The Fed plans to bring inflation back down to 2%. It will ensure there is no recession or stock market crash by tightening monetary policy. 

Rate hike soon: To bring down the inflation, the Fed indicated it is likely to raise the US interest rate in March.. It will be the first increase in the central bank’s benchmark rate since December 2018. It plans to end its bond purchases in March before launching a significant reduction in its asset holding. On an average, the markets are now betting on at least 4 rate hikes in 2022. The US debt market investors are expecting a 30 bps of Fed tightening in March. By the year-end, traders are factoring in 4 increases to take the Fed funds rate to 1.5%, from 0.25% currently.

How did the markets react?

US market ends lower: The S&P 500 ended lower on Wednesday, reversing morning gains after the Federal Reserve released its statement. The Dow Jones fell 129.64 points, or 0.4%, to 34,168.09. The Dow was up more than 500 points at one point, but rolled over after the Fed’s update.  

Bond-yields rise: The US 2-year yield jumped amid expectations of Fed tightening. It has increased to a top of 1.1780% on Thursday morning (IST), a level last reached in February 2020. The benchmark 10-year yield also ticked up from Wednesday's close, rising to 1.8548% from 1.846%. The dollar price has also increased.

Potential impact on the economy

• When interest rates rise, it becomes more expensive to borrow. Hence, consumers are less inclined to buy goods and services, and businesses have a disincentive to borrow funds to expand, buy equipment, or to invest in new projects.
• This lowering of demand for goods and services puts downward pressure on prices, and thus acts to bring inflation under control.

Impact of tightening rates on stocks

• Overvalued tech stocks have been the worst hit as investors fear that higher interest rates will continue to eat away at valuations that the expected to be delivered far into the future
• The types of companies that have suffered the most are ones that don’t have any profits now, but could have rapid growth in the future
• Amid rising interest rates it would be best to focus on profitable companies with a strong balance sheet 
• Financials and industrial stocks with lower debt are expected to fare better an a rising interest rate scenario

How to position your debt investments

• Invest only high-quality AAA-rated bonds as they have the least risk.
• There is a significant tax advantage in holding a debt fund for more than 3 years. 
• For a more than 3-year investment horizon, an investor should prefer short duration (duration < 3) fixed income instruments over a long duration. Stick to short duration funds and bonds, as yields are expected to remain volatile in the near future. 
• Avoid lump sum allocation and adopt a more staggered approach over the next few months.