Higher interest rates upset the stock market as hot inflation tests the Fed

January 12, 2022: -On Monday, U.S. stocks resumed their sell-off as government bond yields continued to trek upward, a hint that many traders grow more confident that the Federal Reserve will move in the coming few months to raise interest rates.

Traders said that the pressure on U.S. stocks isn’t thanks to material concerns about the economy or fears of a massive Covid-19 resurgence but portfolio repositioning for a world with higher borrowing costs.

As the nation’s central bank, the Fed is tasking by Congress to maximize employment and keep prices stable. The Fed is adjusting short-term interest rates and other liquidity tools to keep inflation nearly 2% and cut unemployment as much as possible.

When the Fed is determining that the economy is close to full employment – especially if inflation is hot, it hikes interest rates to make it more challenging for firms to borrow and keep a lid on spending that fuels price increases.

The Labor Department reported in December that consumers’ pay for goods and services increased more than 6% in November and notched their most significant year-over-year increase since 1982.

Many market watchers, which include Charles Schwab’s Randy Frederick, say hot inflation prints all but guarantee Fed rate hikes in the coming months. Members of the central bank had already telegraphed that they plan to restrict access to cash faster than first anticipated.

Those expectations have sent the yield on the benchmark 10-year Treasury note higher in the last weeks, with the rate last seen up around 1.77% from a low under 1.4% in December. Movements in the 10-year yield can eventually directly impact consumers through higher mortgage rates and auto loans.

Frederick, director of trading and derivatives at Schwab Center for Financial Research, explaining that the market appeared to be caught off guard by Chairman Jerome Powell’s pivot away from calling inflation “transitory” and toward more restrictive monetary policy.

“Those are both efforts aiming at fighting the rising inflation, which I think has gone much farther and much faster than had expected,” he said. “So now you have the potential for interest rates, which appeared such as they might not start going up until June. Now there’s such an 80% probability that will happen in March.”

Frederick is not alone in that thinking. The Fed’s meeting minutes, coupled with hot inflation and near-complete employment, led Goldman Sachs to tell clients that it expects four rate hikes this year, more than previously expected.

Markets think there’s a 76% chance the Fed hikes interest rates at the March meeting of the Federal Open Market Committee, up from about 15% in mid-October, according to the CME Group’s FedWatch site.

Monday’s sell-off comes a day before Powell appears before Congress for his nomination hearing. Lael Brainard, whom President Joe Biden nominated to be the central bank’s coming vice chair, will testify on Thursday.

Lawmakers troubled by increasing prices at the gas pump and grocery stores are expected to grill Powell on how he and his colleagues at the Fed are planning to tamp inflation down back toward the Fed’s 2% goal.

But higher rates can cause financial heartburn as traders sell Treasury bonds and richly priced equities.