Markets and financial system brace because the Fed’s first hike might are available two months

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The Marriner S. Eccles Federal Reserve Building in Washington.

Stefani Reynolds/Bloomberg via Getty Images

If all goes according to plan, in just over two months the Federal Reserve will make its first rate hike in three years, a move that policymakers believe is necessary and that markets and the economy are grudgingly accepting.

The Fed last hiked rates in late 2018, as part of a “normalization process” that took place during the slowdown of the longest economic expansion in US history.

Just seven months later, the central bank pulled out as expansion looked increasingly fragile. Eight months after that first cut in July 2019, the Fed was forced to cut its benchmark interest rate to zero as the country faced a pandemic that sent the global economy into a sudden and shocking downturn.

So as officials prepare for a return to more conventional monetary policy, Wall Street is watching closely. The first trading day of the new year showed that the market is poised to continue higher amid the swings that the Fed has welcomed since it signaled a policy shift a month ago.

“If you look back at the Fed historically, it’s usually several tightenings before you get into trouble with the economy and markets,” said Jim Paulsen, chief investment strategist at Leuthold Group.

Paulsen expects the market to take the initial rate hike – likely to be decided at the March 15-16 meeting – without too much fanfare as it was well telegraphed and the benchmark overnight rate is still range bound will increase from 0.25% to 0.5%.

“We developed this stance on the Fed based on the last couple of decades where the economy has been growing at 2% per year,” Paulsen said. “In a 2% shutdown speed economy, if the Fed even thinks about tightening, it’s damaging. But we no longer live in this world.”

Fed officials at their December meeting planned two more hikes of 25 basis points before the end of the year. A basis point is equal to one hundredth of 1 percentage point.

Current Fed-fund futures market pricing suggests about a 60% chance of a March hike and a 61% chance that the rate-setting Federal Open Market Committee will add two more by the end of 2022, according to CME’s FedWatch Tool.

With these subsequent rate hikes, the Fed could experience a setback.

The Fed is raising interest rates in response to inflationary pressures, which, after some measures, are running at their fastest for almost 40 years. Chairman Jerome Powell and most other policymakers spent much of 2021 insisting that prices would soften soon, but conceded towards the end of the year that the trend was no longer “temporary”.

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Whether the Fed can orchestrate an “orderly crash” will determine how markets react to rate hikes, said Mohamed El-Erian, chief economic adviser to Allianz and chairman of Gramercy Fund Management.

In this scenario, “the Fed gets it right and demand softens a bit and the supply side reacts. It’s kind of a Goldilocks adaptation,” he said Monday on CNBC’s “Squawk Box.”

However, he said the danger is that inflation will persist and rise even more than the Fed expects, prompting a more aggressive response.

“The pain is already there so they have to catch up massively and the question is when will they lose their nerve,” added El-Erian.

Market veterans are watching bond yields, which are expected to provide advanced clues as to the Fed’s intentions. Yields have remained largely under control despite expectations for rate hikes, but Paulsen said he expects a reaction that could eventually take the 10-year Treasury benchmark to around 2% this year.

At the same time, El-Erian said he expects the economy to do pretty well in 2022, even if the market faces some headwinds. Likewise, Paulsen said the economy is strong enough to withstand rate hikes, which will push up lending rates on a wide range of consumer goods. However, he expects a correction in the second half of the year if interest rates continue to rise.

But Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, said she believes the market turmoil would be even more pronounced as the economy grows.

Markets are emerging from an extended period of “a prolonged decline in real interest rates that has allowed stocks to decouple from economic fundamentals and widen their price-earnings multiples,” Shalett said in a report for clients.

“Now the period of falling fed funds rates that began in early 2019 is ending, which should allow real interest rates to rise from negative historical lows. This shift is likely to trigger volatility and lead to shifts in market leadership,” she added.

Investors will take a closer look at the Fed’s thinking later this week when minutes from the December FOMC meeting are released on Wednesday. Of particular interest to the market will be discussions not only about the pace of rate hikes and the decision to scale back asset purchases, but also when the central bank will start reducing its balance sheet.

Even if the Fed intends to halt buying in the spring, it will continue to reinvest the proceeds from its current holdings, keeping the balance sheet at current levels of $8.8 trillion.

Citigroup economist Andrew Hollenhorst expects the balance sheet rundown to begin in the first quarter of 2023.