Higher for longer: What the Fed's latest rate hike means for investors

The September FOMC meeting marks an important shift in the policy cycle. After more than three years without a rate increase, the Fed has resumed tightening, citing inflation that remains above target despite a generally healthy labor market and resilient domestic demand. The Committee voted unanimously to raise rates by 25 basis points to 3.75%-4.00%.

What stands out to me is the message embedded in the updated dot plot. Policymakers continue to signal the possibility of at least one additional hike this year and have revised higher their estimates of longer-run interest rates. This reinforces the idea that the neutral rate may be structurally higher than previously assumed and suggests investors may need to adjust to a higher-for-longer interest rate environment.

Chair Kevin Warsh emphasized that inflation remains too high and that policymakers require greater confidence that price pressures are moving sustainably back toward the Fed's 2% target. While growth has moderated and some areas of consumer demand are softening, the labor market remains sufficiently robust to justify continued inflation-fighting efforts.

I don't believe this marks the beginning of an aggressive hiking cycle. Rather, it is a recalibration designed to reinforce the Fed's credibility on inflation. As long as economic growth remains positive and corporate earnings continue to expand, equities should be able to absorb somewhat higher rates.

The greater challenge is likely to be valuations rather than earnings. Higher real yields can place pressure on the most rate-sensitive sectors, particularly expensive growth stocks. At the same time, cyclical sectors, financials, energy and quality value stocks could benefit from a backdrop of resilient nominal growth.

The Fed's message argues against a significant decline in Treasury yields in the near term. The front end of the curve will remain sensitive to inflation surprises and future Fed communication.

However, with policy rates already restrictive and growth gradually slowing, I believe longer-dated bonds are becoming increasingly attractive as portfolio diversifiers.

A hawkish Fed relative to many other major central banks could provide support for the US dollar in the near term. However, the magnitude of the move will depend on whether the Fed ultimately follows through with additional hikes and whether inflation proves as persistent as policymakers currently fear.

Investment risks:

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.