The market had another bad week making it the third one in a row. Despite generally positive earnings from companies reporting in the second quarter, stocks remain under pressure. There are two items impacting the stock markets right now. First, The Fed is increasingly hawkish. Second, the War in Ukraine is affecting energy prices, although the recent COVID-19 closures in China may dampen demand and thus prices.

The Fed Is Increasingly Hawkish

Stock Market Had Another Rough Week

According to StockRover*, every index was down in the US this past week. In addition, nine of the 11 sectors were down. Only Real Estate and Consumer Defensive were up this past week.

Source: StockRover*

The Nasdaq is nearing bear market territory at roughly (-18%) year-to-date (YTD). The Communication Services sector is already in bear market territory, while Technology is close to one.

Will the trends continue down? This question is a difficult one to answer. Earnings are relatively good for many companies despite margin pressures. However, the fear of rising interest rates and future hikes by the US Federal Reserve is pressuring stocks, especially struggling growth stocks.

The Fed is Increasingly Hawkish

The US Federal Reserve is increasingly hawkish due to inflation. In a recent panel discussion, Chairman Jerome Powell indicated that a ½-point increase is on the table. An increase of this size would be the largest since 2000, and it would be the first time rates were increased at two meetings in a row in 2006.

Quoting Mr. Powell,

It is appropriate in my view to be moving a little more quickly…I also think there’s something in the idea of front-end loading I would say 50 basis points will be on the table for the May meeting.

Furthermore, shrinking the Fed’s $9 trillion balance sheet will likely move forward.

Stock markets have reacted poorly to the Fed’s increasingly hawkish stance. On Thursday, the Dow Jones was down more than 400 points, and the Nasdaq was down 2%. Friday was even worse, with the Dow down nearly 1,000 points, the worst day since October 2020. The Nasdaq was down 2.6%, and the S&P 500 Index was down 2.8%.

Consequences of the Fed’s Increasingly Hawkish Stance

Higher Interest Rates

Higher interest rates will hurt some companies but benefit others. For instance, real estate sales should slow as mortgage rates rise and buyers cannot afford larger homes. Growth stocks will be punished as borrowing money for acquisitions, share buybacks, and expansion becomes more expensive. Growth companies tend to take on more short-term debt, which will become more expensive.

However, banks, insurance companies, and brokerages benefit as the marketable securities they keep on their balance sheet earn more interest. Most of these financial companies hold billions of dollars on their balance sheet, so a 0.25% uptick can mean millions of dollars in more income. For instance, Chubb’s (CB) investment income is at a record and will likely go higher in 2022. In addition, higher interest rates mean greater net interest margins and more profit for banks.

Source: US Treasury

Investors can also benefit as short-term investments, like CDs, MMDAs, high-yield savings accounts, and I-Bonds will pay higher interest rates.

Stronger Dollar

Another little talked about aspect of rising interest rates is the USD is getting stronger. The US Federal Reserve is raising interest rates faster than its counterparts in the rest of the world. This fact means US Treasuries are more attractive to global investors. The table below shows the 10-year bond yield by country. Why invest in bonds at low rates when the US 10-year bond pays almost 3%?

Source: World Government Bonds

Furthermore, global investors are fleeing risk, which means they are leaving emerging markets and buying US Treasuries. The result is a stronger dollar. The charts below show the USD versus the GBP, Euro, Yen, and Yuan.

Source: Trading Economics

Source: Trading Economics

Source: Trading Economics

Source: Trading Economics

The net result will be US exports are more expensive while imports are cheaper. This point should help reduce inflation in the US. It will also mean foreign investment in the US should rise.

Final Thoughts on the Fed is Increasingly Hawkish

The Fed will likely increase the Federal Funds rate by 0.50% in early May after a 0.25% increase in March. Some analysts and traders are pricing in a 0.75% increase, but that seems unlikely. In addition, the Fed will start reducing its balance sheet. Both actions will place upward pressure on interest rates. Countering that upward pressure will be increased buying for the US and international investors of US Treasuries. However, the Fed will remain increasingly hawkish until inflation comes down. As a result, investors should expect more volatility and the possibility of a recession.