Fed Rate Hikes Impacting Wall Street, Broader Economy

For much of the past year, we've had the dynamic of the economy improving, and rates trending higher as the Fed focused its efforts on tamping down inflation. Now, we are seeing recession odds increase while inflation odds decline.

Until mid-May, cyclical stocks were flat on the year, while the S&P 500 (NYSE: SPY) was down 15%. Here is where things have totally turned, and it may be seen in hindsight as the Federal Reserve committing an unnecessary policy error as inflationary pressures may have been ebbing on their own.

If we study previous hiking episodes, we see that rate hikes have an immediate impact on the housing market as demand is sensitive to changes in mortgage rates. Thus, we saw mortgage applications plummet as rates hit 6%.

Now, 6% mortgage rates are not a big deal historically, but they are pretty high relative to the rest of the decade. And, this certainly has an impact on affordability as well as refinancing. This is also evident with the SPDR Homebuilders ETF (NYSE: XHB) which is down nearly 40% YTD.

Rates were trending higher for most of 2021 at a mild rate, but their gains accelerated in 2022 as the Fed pivoted to an even more hawkish stance. This intensified with the Fed's 75 basis point hike at its June meeting while signaling that a similar hike was likely in July and that rates could end the year above 3%.

The dampening effect of higher rates is starting to affect manufacturing which is slowing. It remains in expansion mode but leading indicators like New Orders are now negative, implying that contraction is likely. Until the Fed's recent hawkish pivot, this had been outperforming, but it could overcome the headwind of higher rates for only so long before it had to succumb.

The next shoe that could drop is earnings. So far in 2022, estimates for 2022 EPS have modestly increased due to better than expected numbers. However, the market seems to be anticipating a decline in earnings. So far, market weakness has been more about multiples compressing rather than earnings declining. If inflation is peaking, then further market weakness would have to come from weaker economic data.

As we see many parts of the economy are weakening which adds to the argument that inflation is turning. The one exception has been food and energy but even here we see big drops in ag commodities and energy prices. Many oil and oil stocks are now trading below levels prior to Russia's invasion of Ukraine. This action only makes sense in a scenario if we are going to have a recession.