2022 Review: War & Fed

2022 was a year of volatility. The Equity Market was virtually on a downtrend until some recovery by the end of the year. There were two key factors behind the drop: the Russia-Ukraine war which started in February and the monetary policy, which the Fed tightened by aggressively hiking interest rates to tackle inflation. 

The war made supply chains that had been disrupted by Covid to become more complicated, especially the prices of commodities, which have been pushed up. This fueled inflation around the world. Inflation was inevitable anyway because of Covid related fiscal, monetary support, and supply chain issues, but the war made it worse. That’s why some developed countries experienced double digit inflation rates that should only be seen in developing countries. When inflation becomes so high and escalating, the Fed has no choice but to hike interest rates.   

The Fed was wrong to believe that inflation was transitional in 2021 and missed the best timing to hike the rate. The war exaggerated the situation and threatened for inflation to run out of control. In hopes of bringing down inflation, the Fed hiked rates aggressively, bringing the Fed Fund Rate from 0-0.25% to 4.25-4.5% this year. Although the Fed slowed the pace of hiking to 50 bp in the December meeting, they believe their mission hasn't been accomplished.

CBOT Fed Fund Rate Futures vs Inflation

It is common to see the Equity Market go down during interest rate hike cycles, especially if the reason behind the hike is solely about inflation. When interest rates increase, the valuation of a company goes down because earnings will be discounted to present value using a higher discount rate. Not to mention that a potential recession triggered by the hiking rate will have a negative impact on revenue and earnings. Growth stocks have been impacted most since their valuation is biased to future earnings that have been discounted at a higher rate.  

CME US Equities Futures

The US dollar is amazingly strong because of safe-haven flow and Interest Rate Differential. Foreign currency rebounded in the fourth quarter due to investor betting. The Fed is approaching the end of the hiking cycle and risk sentiments have improved. 

CME Currency Futures

When the Fed hiked the rate, treasury yields also went up, with the 2-year yield increasing much more than the longer-term yields, making the yield curve inverted in a larger extent. Historic data shows that the inversion of the yield curve forecasts a recession.

CME Micro Treasury Yield (2Y vs 10Y) Futures

We will have a 2023 forecast in the next publication. Stay Tuned!