The Fed’s Most Aggressive Hiking Cycle in 40 Years Begins

Khan Capital | March 2022

On 16 March 2022, the Federal Reserve raised the federal funds rate by 25 basis points, lifting it from the 0-0.25% range where it had been anchored since March 2020. What was not fully appreciated was the velocity of what would follow: the fastest monetary tightening cycle in four decades, a campaign that would ultimately take the fed funds rate to 5.25-5.50% through eleven hikes over 16 months, reshape every asset class on the planet, and lay the groundwork for both the 2023 banking crisis and the most significant repricing of risk-free rates in a generation.

The Fed’s March dot plot projected seven rate hikes in 2022 and a terminal rate around 2.75%. The actual outcome would far exceed these projections.

Why Now: The Inflation Story the Fed Missed

The CPI had reached 7.9% year-over-year by February 2022, its highest reading since January 1982. Core PCE was running at 5.2%. The term “transitory” had been officially retired by Chair Powell in December 2021. The Fed had maintained zero interest rates and continued purchasing $120 billion per month in securities through November 2021, even as inflation was running at three times its 2% target.

Russia’s invasion of Ukraine on 24 February 2022 added a potent supply shock, with Brent crude touching $130 per barrel. The inflationary impulse from the war reinforced rather than caused the underlying price pressures.

The Acceleration: From 25bp to 75bp

In May, the Fed delivered a 50-basis-point hike. In June, facing a CPI print that would reach 9.1%, the FOMC raised by 75 basis points: the largest single hike since 1994. The June move was itself a departure from earlier guidance; just weeks before, Powell had stated that 75bp hikes were “not something the committee is actively considering.”

The 75bp pace was sustained through July, September, and November 2022: four consecutive jumbo hikes that took the fed funds rate from 1.50% to 4.25% in just four months. The terminal rate of 5.25-5.50% was reached in July 2023.

The Market Response: Everything Repriced

Equities: The S&P 500 fell 25% from its January 2022 peak to its October 2022 trough. The Nasdaq declined approximately 35%. The ARK Innovation ETF fell over 75% from its 2021 high.

Fixed income: The US aggregate bond index delivered its worst annual return in recorded history in 2022, falling approximately 13%. The 60/40 portfolio suffered its worst performance since 2008 as stocks and bonds declined simultaneously.

Currencies: The US Dollar Index surged to a 20-year high. The yen fell to 150 against the dollar, its weakest since 1990, prompting the first Japanese currency intervention in 24 years. The euro briefly fell below parity for the first time since 2002.

Real estate: Mortgage rates doubled from approximately 3% to over 7%, the fastest increase in decades.

Crypto: Bitcoin fell from approximately $47,000 to below $16,000, a decline of over 65%.

What the Market Is Misunderstanding

The terminal rate will likely exceed current expectations. As of March 2022, the market is pricing a terminal rate of approximately 2.75%. History suggests the Fed consistently underestimates the level of tightening required when inflation is this embedded.

The “soft landing” probability is lower than consensus assumes. Of the 14 Fed tightening cycles since 1950, 11 have been followed by recessions. The Richmond Fed noted this cycle is “unique in terms of both the speed at which interest rates rose and the movement of inflation during the series of rate hikes.”

The lag effects of monetary policy are being underestimated. The front-loading of rate hikes in 2022 means the most significant economic effects will not be felt until mid-2023 at the earliest.

Quantitative tightening is the overlooked variable. In addition to rate hikes, the Fed began reducing its balance sheet in June 2022 at up to $95 billion per month. The combined effect of higher rates and QT has no modern precedent.

Structural Interpretation: The End of the Low-Rate Regime

The March 2022 rate hike marks not just the beginning of a tightening cycle but potentially the end of an era. From 2008 to 2022, the prevailing assumption was that interest rates would remain permanently low. This assumption underpinned asset valuations across every class. If the neutral rate of interest is higher than near-zero, then the entire framework for valuing assets requires recalibration. This is a structural shift, not a cyclical one.

Implications for Investors

Duration is the enemy in a hiking cycle. Investors may wish to shorten portfolio duration across both fixed income and equity holdings until the rate trajectory stabilises.

The 60/40 portfolio needs rethinking. Alternative diversifiers, including commodities and real assets, deserve consideration.

Cash is no longer a drag on returns. For the first time in over a decade, short-duration instruments offer meaningful yields.

Conclusion

The first rate hike of March 2022 was the opening move in the most aggressive Fed tightening campaign since Paul Volcker’s era. Every asset class on the planet is being repriced to reflect a world in which the cost of capital is no longer zero.

Key Takeaways

• The Fed’s 25bp hike on 16 March 2022 began the most aggressive tightening cycle in 40 years, ultimately delivering 525 basis points of increases over 16 months to a terminal rate of 5.25-5.50%.
• CPI reached 9.1% by June 2022, forcing the Fed to accelerate to four consecutive 75bp hikes, the largest single-meeting moves since 1994.
• The repricing was comprehensive: the S&P 500 fell 25%, the Nasdaq declined 35%, the US aggregate bond index posted its worst year in recorded history, and the dollar hit a 20-year high.
• The 60/40 portfolio suffered its worst performance since 2008 as stocks and bonds declined simultaneously, challenging the foundational assumption of modern portfolio construction.
• The hiking cycle potentially marks the end of the post-2008 low-rate regime, requiring a structural recalibration of asset valuations and risk management frameworks.

Sources: CNBC, Federal Reserve Bank of Richmond, World Economic Forum, Bankrate, WEF (Rate Hike Comparison)

Related Reading

The inflationary pressures that forced this pivot were first debated in The Inflation Debate: Team Transitory vs. Team Persistent and reached crisis levels as covered in Inflation Hits 6.8%: The Fed Retires ‘Transitory’ and The Great Taper: Fed Signals End of Easy Money Era. The rate hiking cycle ultimately reached its peak, as we covered in Fed Funds at 5.5%: The End of the Hiking Cycle? The banking crisis that resulted from these hikes is analysed in Silicon Valley Bank Collapse: The Fastest Bank Run in History. For the parallel European tightening, see ECB Finally Hikes: End of Negative Rates in Europe. The Pfizer vaccine announcement that repriced the end of the pandemic is covered in Vaccine Day. The fiscal response that complemented the Fed’s monetary intervention is covered in the CARES Act.