Another Big Fed Rate Hike To Drive ETFs

Investors are gearing up for a second-straight 75 basis point interest rate hike from the Federal Reserve, as implied probabilities based on fed funds futures suggest there is a 75% probability of the move on Wednesday. 

That would match the 75 basis point hike in June, which was the biggest interest rate increase since 1994. While the 75 basis point increase is the most likely outcome, markets are leaving open the possibility for the U.S. central bank to be even more aggressive, with a 100 basis point hike; the probability of that occurring is estimated at 25%. 

Regardless of the outcome of the Fed’s decision, stock ETFs like the SPDR S&P 500 ETF Trust (SPY) and bond ETFs like the iShares Core U.S. Aggregate Bond ETF (AGG) are likely to feel the impact. 

Either a 75 basis point or a 100 basis point move would be aggressive and reflects the bind that the Fed finds itself in. Consumer prices are growing at their fastest pace in four decades, and the central bank is being blamed for initially being too slow to tighten monetary policy.

Now it’s having to play catch-up with these monster interest rate hikes, even as the economy shows signs of slowing. 

The risk of economic weakness may be why a handful of Fed officials have pushed back against the larger 100 basis point hike even in the face of fiery inflation. “Moving [interest rates] too dramatically will undermine [the economy],” Federal Reserve Bank of Atlanta President and CEO Raphael Bostic warned a little over a week ago. 

Federal Reserve Bank of St. Louis President James Bullard, who has been a Fed hawk in the past, said he was indifferent to whether the central bank hiked 75 basis points or 100 basis points, though he wants to see the federal funds rate lifted to 3.75-4% by the end of the year. 

If the Fed were to hike rates by 75 basis points on Wednesday, that would push the fed funds rate to a range of 2.25-2.5%. Fed funds futures currently imply that the rate will peak in November at 3.25-3.5%—though there is an enormous amount of uncertainty in the path of interest rates given shifting inflation and economic growth dynamics. 

Market’s Reaction  

Markets may look past how much the Fed hikes rates by on Wednesday and toward what the central bank might do in the future. For clues on that, Fed Chair Powell’s post-decision press conference will be closely scrutinized.  

After the Fed hiked rates on June 15, the SPDR S&P 500 ETF Trust (SPY) climbed 1.4%, but then it fell 3.3% the next day and 0.2% the day after that, closing at 3,666.77. As of today, that’s the lowest closing level for the S&P 500 so far during this bear market.  

S&P 500 

Meanwhile, bonds bottomed out the day before the Fed’s last rate hike, when the 10-year Treasury bond yield reached 3.5%. It’s since fallen to around 2.75%, lifting prices for most bond ETFs (bond prices and yields move inversely). 

On a year-to-date basis, the iShares Core U.S. Aggregate Bond ETF (AGG) is currently lower by 8.7%, an improvement from the 12.5% loss it had on June 14. 

 
AGG YTD Return (Blue) Vs 10-Year Treasury Bond Yield (Orange) 

All of this suggests the market’s reaction to this week’s Fed rate hike is unknowable, with many variables up in the air. 

There is a good bit of breathing room between current stock and bond prices—their lows that were set just before and after the last Fed rate hike. Investors will see whether those lows hold in the coming days and weeks. 

What the Fed does will play a role in determining that, but the central bank is arguably reacting to forces out of its control. If inflation remains persistently high, it will have to keep pressing on the monetary brakes. If inflation cools or the economy tanks, it might prematurely end its rate-hiking campaign or even reverse course. 

The Fed is scheduled to make its interest rate decision on Wednesday, July 27 at 2 p.m. ET, which will be followed by a press conference with Fed Chair Jerome Powell at 2:30 p.m. ET. 

Follow Sumit Roy on Twitter @sumitroy2