• On Wednesday, the Nasdaq was up about 3% on the Fed rate hike news.
• On Thursday, the Nasdaq fell 5% as the reality of hiking set in.
• This volatility is not indicative of a healthy market.

Big Rate Hikes Arent Happening, Thank Heavens!

1. 1. The Fed raises the Fed Funds target band.
   2. As a result, market rates like mortgage rates should rise as well.
   3. A higher rate reduces asset prices, as the cash flows are discounted at a higher rate.
   4. Expectations and confidence are hit as the punch bowl is taken away.
   5. The dollar should strengthen, as higher rates make people deposit more into dollar accounts.
   6. Domestic demand and net external demand (exports minus imports), which make up total demand, should fall as expectations are reduced, and exporters goods are more expensive for overseas buyers.
   7. Imports become cheaper as the dollar increases in value.
   8. As a result of the above, inflation is reduced.

Of course, its more complicated in reality, and the moves dont always go as planned.

But its important to note that the Bank of England, Englands central bank, believes it takes between 9 and 12 months to get from point 1 to point 6.

And then it takes another 9 - 12 months to get from lowered demand to lower inflation.

In all, one rate move needs 18 to 24 months to work its magic.

But the Fed - and very different central bank - believes it can ratchet the economy up or down at will.

This has never proven to be the case without dire consequences.

In fact, the last time the Fed hiked so quickly was the year 2000.

And we all know what happened to tech stocks then.

The Markets Get Excited

With all this said, why did the markets rally so hard on Wednesday?

Yes, the Fed hiked rates by 0.50%, or 50 basis points (bps).

The markets then furiously rallied.

Jay Powell mentioned the following:

A 75-basis-point increase is not something that the committee is actively considering I think expectations are that well start to see inflation, you know, flattening out.

Ok, so 75-bp hikes are off the table.

Thats great.

But I think the market got overly excited about it.

But not only is the Fed hiking rates, but its also going to start its asset tapering.

Source: Capital Economics

Remember, the Fed currently holds an enormous amount of US Treasury securities.

From The Balance:

As the nation's central bank, the Federal Reserve is in charge of the country's credit. It doesn't have a financial reason to own Treasury notes. So why does it?

The Federal Reserve actually tripled its holdings between 2007 and 2014. The Fed had to fight the 2008 financial crisis, so it ramped up open market operations by purchasing bank-owned mortgage-backed securities. The Fed began adding U.S. Treasurys in 2009. It owned $1.6 trillion, by 2011, maxing out at $2.5 trillion in 2014.

This quantitative easing (QE) stimulated the economy by keeping interest rates low and infusing liquidity into the capital markets. It gave businesses continued access to low-cost borrowing for operations and expansion.

The Fed purchased Treasurys from its member banks, using credit that it created out of thin air. It had the same effect as printing money. By keeping interest rates low, the Fed helped the government avoid the high-interest-rate penalty it would incur for excessive debt.

The Morning After

The stock market took its biggest U-turn since the early days of the pandemic Thursday, with the Dow Jones Industrial Average posting its largest decline this year just 24 hours after its largest gain since 2020.

Wrap Up