Fed Rates

The cheerleaders of passive indexing have fallen quiet after a decade of yelling that passive indexing is the only way to invest money. As I have stated many times, passive indexing looks great in bull markets. However, it can be a very quick way to destroy capital in bear markets.

The third quarter started with renewed investor optimism but ended with a crushing reminder that the worst is yet to come. The bear market rally that started in mid-June continued through July and into August. However, further signs of sky-high inflation, necessary interest rate hikes, and increasing probability of a “hard landing” and recession in 2023 smashed all hope. Between mid-August and the end of September, the S&P 500 Index dropped almost 17% and closed out the quarter at a new bear market low of 3585.62 (over 100 points below the prior low reached in mid-June).

You may have noticed that the market cycle has changed along with the Fed’s monetary policy shift to fight inflation. With inflation soaring, it is clear that the Fed is way behind the curve on raising interest rates. They will likely stomp on the proverbial breaks in an attempt to rapidly slow the overheated economy and inflation. When the Fed moves into this type of posture, they have caused a recession about three-quarters of the time. And recessions are typically correlated with bear markets.

Last week ended with the realization that inflation hadn’t peaked. This week began with markets pricing in a 75 bp rate hike based on a whisper from someone who was in the know. The Fed’s hike puts the U.S. on the steepest tightening path in the G-10, up 1.50% so far this year. To slow inflation and rising prices, the Fed needs to reduce consumption demand. As demand cools, companies take note and start to reduce spending, and then as a second step, curtail employment. This causes the economy to shift into recession which can quickly reduce corporate profits.