This week, we're diving into The Fed's latest moves and their impact on the economy. Our analysis will give you a peek into how the stock market might react to their monetary balancing act. Plus, we've got a fascinating deep dive into the historical returns of the market in various interest rate scenarios.

You can read last week's review here.

The Fed are trying to mitigate the risk of a systemic banking crash while keeping an eye on inflation. Their actions over the past 4 weeks have been contradictory.

• The Fed has risen interest rates to combat inflation.
• They have also expanded their balance sheet to backstop the bank's bond losses. This expansion of liquidity will increase inflation.

It's unlikely that rates will remain at these high-levels for long. The market is pricing in rate cuts by July, with a 93% probability.

Let's address the crucial question: How does it impact the stock market?

We analyzed the forward returns of the market under different interest rate environments. We calculated the 3-year nominal forward returns and grouped them into buckets based on the interest rate of that time. Forward returns tell us the future return of the market at a given period in history, and we can use this to set performance expectations. Our dataset starts in 2000. The chart below clearly shows a strong relationship between interest rates and future market returns.

The current interest rate lies in the 4% -> 5% range and suggests that nominal forward returns for the S&P 500 will be negative over the next 3 years. Diversification can protect investors. We generated a simple Tactical Switch Strategy with the S&P 500 and gold. It outperforms a buy-and-hold strategy by adding diversification to an investor's portfolio.

Additionally, we can examine the relationship between stocks and interest rates. Note that since 1995, there has been a positive correlation between stocks and interest rates, indicating that they have moved in tandem. This is a surprising discovery. We we can see in the chart below, the mean correlation is not particularly strong.

During periods of financial distress, when the Fed has cut rates to boost a struggling stock market, the correlation has peaked. We have identified two previous high-correlation periods, which were the Great Financial Crisis and the Covid-19 pandemic. The present-day correlation has just turned negative.

As the Fed continues to increase interest rates, regional banks are coming under added pressure. The reasons for this are many:

1. With the rise in interest rates, banks are amassing unrealized losses on their bond investments. A significant number of banks bought held-to-maturity bonds, whose worth has declined in line with the higher interest rates available today.
2. Nevertheless, this circumstance alone is not fatal. It is only if depositors come looking to withdraw their cash that the bond losses have to be realised. This is exactly what has happened with many of the regional banks, who deposits have not been guaranteed by the Fed. Illiquidity and even insolvency has plagued the smaller banks.
3. This pain has been compounded by the fact that banks cannot offer returns comparable to short-term treasury bills, and therefore depositors have been rushing for the exits.

The likely impact of the banking crisis is a consolidation of capital into the hands of the largest U.S. banks such as J.P. Morgan and City Bank, as investors will pour assets into the 'too big to fail' banks.

If you are interested in creating a diversified portfolio with multiple asset classes, you can use our Xplore ETF tool to do just that.

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