Here’s What Happens To Stocks When The Fed Raises Rates By 100 Basis Points

Stocks have continued to struggle for direction since a hotter-than-expected inflation report earlier this week dragged markets to their worst single-day drop since June 2020, with the Dow plunging over 1,200 points. While inflation remains stubbornly high, investors have grown increasingly concerned that the Federal Reserve will plunge the economy into a recession as it continues to aggressively raise interest rates.

Though most Wall Street experts still predict that the Federal Reserve will raise interest rates by 75 basis points at its policy meeting next week, expectations for a more aggressive 100-basis-point hike have slowly been rising.

Another red-hot inflation report on Tuesday all but confirmed for markets that the Fed will raise rates by 75 basis points or more next week. The consumer price index rose 8.3% in August compared to a year ago, higher than the 8.1% increase expected by economists. Though that number is still down from 8.5% in July and 9.1% in June, core inflation, which excludes volatile food and energy prices, has remained elevated. Core inflation increased 0.6% on a monthly basis in August, amounting to twice what economists were predicting and double last month’s 0.3% increase.

Though markets still widely expect a 75-basis-point rate hike, risks are now skewed to the upside—with investors completely wiping out the odds of a smaller 50-basis-point rate hike following the inflation report on Tuesday. Traders are instead now pricing in a 20% chance that the Fed will raise rates by a bigger than expected 100 basis points, according to CME GroupCME
Data.

Economists at Nomura Securities changed their forecast for the upcoming Fed meeting, which concludes next Wednesday, and now predict the central bank will raise rates by 100 basis points—followed by 50-basis-point increases at each of the meetings in November and December. “The August CPI report . . . suggests a series of upside inflation risks may be materializing,” the firm wrote.

If the central bank does hike rates by 100 basis points next week, “then people would really get concerned because it would imply that the Fed does not have confidence in its own timetable and indeed could end up tightening too dramatically and throw the economy into a recession,” predicts Sam Stovall, chief investment strategist for CFRA Research.

The last time the central bank raised rates by 100 basis points was over four decades ago, when Paul Volcker was Fed chairman. The Fed raised rates by 100 basis points seven times between November 1978 and May 1981 (after Volcker had taken the helm), according to CFRA Research. Inflation stood at 9% in November 1978 before peaking at 14.6% in March 1980, while core inflation was at 8.5%—peaking at 13.6% in June 1980.

Markets fell nearly 60% of the time, with the S&P 500 losing an average of 2.4% one month after a 100-basis-point rate hike, according to CFRA data. While stocks were still down three months after a rate increase of that magnitude (falling 1.3% on average), markets eventually leveled out by the six-month mark, with the S&P rising an average of 0.1% by that time.

Volcker was responsible for six of the seven historic 100-basis-point rate hikes (the first came under his predecessor, G. William Miller). With a strong focus on bringing down inflation by any means necessary, Volcker immediately raised rates by 100 basis points four times in 1980, soon after taking office. Interestingly, the S&P 500 actually gained 25% that year, though the Fed’s big rate hikes would eventually catch up to the economy, plunging it into a recession from 1981–82.

Prior to Volcker, in the 1970s then Fed chair Arthur Burns was slow to respond to rising inflation, zigzagging between raising and lowering interest rates. “The problem is that it never really solved inflation,” says Stovall, adding, “the Fed doesn’t plan on making the same mistakes from the 1970s.”

Despite some similarities to the great inflationary period 40 years ago, the economy appears stronger this time around, thanks to a solid labor market and steady consumer spending. It remains to be seen whether the Fed can orchestrate a soft landing or whether its aggressive monetary tightening will eventually plunge the economy into a recession, similar to that of the early 1980s during Volcker’s tenure.

The latest economic data on Thursday morning showed the picture remains very muddled—with retail sales coming in below expectations, weekly unemployment claims falling and the Philadelphia Fed’s manufacturing survey turning negative. The economy is still holding steady for now—especially thanks to a strong labor market, which should temper expectations for a larger 100-basis-point rate hike next week, experts say.

“The pace of rate hikes in the rest of 2022 and 2023 will depend on how quickly a cooler economy translates to a cooler job market,” says Bill Adams, chief economist at ComericaCMA
Bank, who predicts a 75-basis-point increase next week.

“The implication is that if we were to get a 100 basis points, it would throw the market for a loop and put a lot of pressure on equities,” says Stovall. “Markets have given the Fed a pass for raising by 75 basis points—nobody is going to say that’s too fast.”

Source: https://www.forbes.com/sites/sergeiklebnikov/2022/09/15/heres-what-happens-to-stocks-when-the-fed-raises-rates-by-100-basis-points/