The Stock Market Jumped After a Rate Hike; What This Should Tell Investors

Yesterday, following their scheduled two-day meeting, the Fed did exactly what everyone had forecast they would do, and raised interest rates by a quarter of a point. It should probably have been a big non-event given that the bond market had, the day before, priced in a 98-99% chance of that being the outcome. If anything, with Fed Chair Jay Powell talking tough about how we still had a long way to go to tame inflation and saying there was little to no chance of cutting rates any time this year, you might have thought it would produce a mildly negative response. But this is how the E-Mini S&P 500 futures contract (E/S) reacted:

After an initial dip, it was almost as if Powell had delivered a positive surprise and said something along the lines of there would be no increase at all, or maybe saying that he could see cuts on the horizon before too long.

But that wasn’t what he said. Instead, he said that while there was some improvement in price data, the key metric that the committee was now monitoring was the jobs numbers, and implied that they wouldn’t stop squeezing until there was a significant move there. In other words, to say that he wants to see a real negative impact on the economy before even pausing the increases would probably be a fair summary. And yet, the market cheered. Why would that happen?

The obvious reason is that traders just don’t believe him.

They have decided that, based on the fact that he was too slow to react when it came to starting to raise rates, he will also be too late when it comes to stopping the hikes and have to cut before the year is out. For all of Powell’s protestations, or maybe in part because of them, it is hard to fault that thinking.

He has shown himself to respond to data, something that should be admirable but creates a problem in this situation. The data is backward looking by their nature and, in order not to be misled by an outlier, economists prefer to look at multi-month trends or three-month moving averages of data. Powell takes the same approach. That means that he and the committee are always going to respond to any significant move three months after it starts. Historically, in the slow-moving world of macroeconomics that wouldn’t matter, but in the much faster world of markets that try to predict and get in front of events, it does.

So, traders may well respect the sincerity of Jay Powell when he says that he intends to closely watch the labor market and ease up just as the jobs numbers start to respond, they also know that getting it exactly right is almost impossible, and that the backward-looking nature of the data makes overshooting the mark likely. The good news, I suppose, is that they see that possibility and the resulting policy reversal as a positive overall, hence the buying.

Still, even in the days of algorithms, AI, and HFT, there is one mistake that remains possible, something that has happened in the past and will again: At times, traders, or the software that they control, get the sequence of events right, but the impact of those events wrong. There is a real danger that will happen here. Just as inflation can become a vicious cycle with price increases causing wage increases that prompt price increases, it can happen in the opposite direction. Lower wages and unemployment can cause reduced spending, cutting demand and forcing companies to cut the cost of labor, meaning cutting jobs and wages.

One of the things that those of us of a certain age remember about the 70s and 80s, the last time when inflation was this much of a problem, was that fighting it often ends up being a boom or bust thing. Attempts to control it do real damage to the economy and force a pivot, which quickly causes overheating. The brakes are slammed on again, and so on and so forth. The market reaction to the Fed’s decision and Powell’s words suggest that what we might see over the next year or so could be the Fed jumping one way and then the other, creating a "red light, green light" dynamic, with an end result that is hard to predict.

It is hard to see the jump in stocks in reaction to a rate hike as anything other than an unequivocally good thing, but its implications hint at the potential for chaos to come. I for one will remain cautious until the picture is clearer.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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