THE FED MIGHT YET AGAIN TAKE THE PUNCH BOWL AWAY / THE FINANCIAL TIMES MARKETS INSIGHT

The Fed might yet again take the punch bowl away

Potential rate rises could give way to a broad range of investment opportunities

Richard Bernstein

Federal Reserve chair Kevin Warsh © Tom Williams/CQ-Roll Call/Getty Images

When investors can’t tell the difference between financial markets and prediction markets, it’s clear that speculation is flourishing. 

Investors should consider what might curtail the current casino atmosphere.

Financial markets exist to spur capital formation. 

Companies raise capital by issuing stocks and bonds to expand plant, equipment and employment. 

As a conduit connecting available funds with productive investment, the financial markets contribute significantly to economic growth, productivity and standards of living.

Prediction markets, however, contribute virtually no economic value added. 

Placing a bet on whether a team wins a game or if a certain word appears in a celebrity’s award acceptance speech does nothing to enhance economic productivity.

One would never equate the NYSE’s economic importance with that of a corner bookie, but current market conditions seem to assume their roles are identical.

Central banks are crucial to capital formation because they set the lending rate upon which assets are valued. 

Investors tend to add portfolio risk when central banks lower interest rates because short-term deposits become less attractive relative to the potential returns of stocks and bonds. 

But central banks can constrain risk-taking by raising rates and luring funds away from riskier assets.

Speculation can occur when central banks set interest rates too low and funds flow into investments that might otherwise be considered imprudent. 

It plays a healthy role in the economy, but too much results in bubbles that are inherently inflationary. 

Bubbles overcapitalise some sectors of the economy while others go hungry. 

Undercapitalised sectors can’t expand and if they then can’t meet demand, prices increase.

For example, today’s rush to build AI data centres does nothing to alleviate inflationary pressure resulting from persistent supply chain disruptions, a dilapidated and antiquated electric grid, the inability to expand or maintain the military stockpile and the lack of refineries that process US shale oil.

In December 2025, economists were largely predicting multiple interest rate cuts for the year ahead. 

Our investment thesis entering 2026 was that the Federal Reserve would not be able to cut interest rates as quickly as investors expected. 

The nominal economy seemed too strong to warrant multiple rate cuts without spurring significant inflation.

Our forecasts were not far off target. 

Inflation is indeed higher than investors expected, nominal GDP is tracking at roughly 7 per cent, and the insatiable flow of capital towards AI-related themes has helped aggravate shortages by hindering other sectors’ expansion. 

Fed funds futures are now beginning to price in rate rises that might curtail speculation.

As history suggests, the threat of higher short-term interest rates has begun to lead to speculative assets’ underperformance. 

Business development companies were the first to feel the pinch and the S&P BDC index is down about 20 per cent from its peak despite recovering somewhat.

Bitcoin has fallen more than 50 per cent from its peak. 

Some argue the so-called Magnificent Seven and semiconductor stocks are starting to follow a similar path.

In a world of aggressive risk-taking, two more mundane equity market segments seem attractive. 

First, investors are ignoring dividend-paying stocks because of their enthusiasm for exciting growth stories. 

Despite the huge outperformance of the technology sector over the past several years, the total return of the S&P Dividend Aristocrats index remains substantially higher than Nasdaq’s since the peak of the 1999-2000 technology bubble. 

The compounding of dividends isn’t headline-making, but it remains one of the easiest and most effective ways to build wealth.

Second, non-US stocks’ humdrum combination of superior dividend yields, lower valuations and increasingly competitive earnings growth makes them attractive. 

Non-US stocks comprise roughly 35 to 40 per cent of the global equity markets, but investors consider them so boring that they have paltry allocations to non-US stocks.

The old saying is that the Fed spoils bull markets by raising rates and “taking the punch bowl away from the party”. 

While many could view any such repeat of history as bearish, we see the Fed’s potential rate rises as spurring a healthy capital reallocation within the US economy that presents a broad range of investment opportunities.

The writer is global head of macro investing at Janus Henderson Investors