It should come as no surprise that on Wednesday the Federal Reserve raised interest rates by 0.5%.

And in doing so, the major indices enjoyed one of their biggest one-day rally in years.

The S&P 500 closed 3% on the day and the Nasdaq 100 gained 3.4%.

When the Fed hikes rates, you’d expect stocks to fall, not rally.

But this was a relief rally…

Relief because the Fed didn’t increase rates even higher than expected. This pushed the bulls back into the market.

During its meeting, the Fed ignored calls for a 0.75% rate raise and ruled out a raise of this size for the rest of 2022.

Instead, the market can now expect consistent 0.5% raises. The target rate will likely be around 3% by the end of 2022.

So, without a potential mega-rate raise – and after falling heavily since the start of 2022 – the market rallied.

After a rough start to the year, investors are enjoying the bounce. And the bulls are again singing the same tune…

The economy is strong, consumers are still spending, and that the Fed will somehow time its rate hikes so perfectly – that it’ll rein in inflation without causing a recession.

But all I can say is… good luck with that.

Despite expected 1.1% growth, gross domestic product (GDP) contracted at 1.4% last week. Next quarter’s print will be even more important.

Another soft GDP number means the Fed will increase rates at the same time the economy is already slowing. And with 8.5% inflation, we’re barely at the beginning of a massive tightening cycle.

The Fed simply left it way too late to start raising rates. It is now stuck trying to kill off inflation with the limited lever of monetary policy.

Increasing interest rates won’t do anything to stem the commodity inflation caused by the Ukrainian invasion…

Nor will it do anything to alleviate the massive supply chain disruption caused by severe and continuous COVID lockdowns in China.

The Fed and the markets are grappling with two of the most basic economic truths that they’ve tried to ignore for years…

First, if you endlessly print money, you’re going to get inflation. While the U.S. economy avoided inflation for nearly a decade, inflation has now risen sixfold since the start of 2021.

Second, there’s a relationship between interest rates and the value of money.

If the cost to borrow money is next to nothing, then does that money have any real value?

When inflation is higher than borrowing costs, people are encouraged to speculate. Folks will borrow more and more, until it leads to asset bubbles like the ones we have now.

These same folks work out those assets’ real worth, only after interest rates start to rise.

We’ve seen this before… from the subprime crisis of 2007 to the “dot-com” bubble of 2001. Once these asset bubbles unwind, the markets go into a meltdown.

And this is what the Fed is juggling now…

It must rein in 40-year high inflation without pulling the rug out from the entire economy.

The reason the Fed raises rates is to slow down demand. The aim is for consumers to cut back on their spending.

But the more the Fed raises rates, the more consumers will cut back on that spending. And this leads to lower company earnings – even if it takes a couple of quarterly results to come through.

Higher rates with slower earnings will place an ever-growing weight around the market. And this is what the market must absorb over the next couple of years.

Enjoy any bounce in the markets… However, investors need to understand that the “buy the dip” game has passed.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

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