Fed hikes are (probably) done. Now what?

It's not official yet, but it sure seems likely that Jerome Powell and the Federal Reserve have reached the end of their rate-hiking cycle.

The Fed's most recent hike on May 3 elevated the Fed Funds Rate (now 5% to 5.25%) above year-over-year inflation (4.9%) as measured by the Consumer Price Index. Historically, that's a significant milestone. With inflation on a steady path lower, and the U.S. financial sector destabilized by the recent failures of several regional banks, conditions seem ideal for the Fed to hit its long-awaited PAUSE button.

So, with the process (probably) complete after 14 months and 10 separate hikes, what should investors expect from here?

For starters, expect economic growth to continue slowing even though monetary policy moderates. First-quarter GDP grew 1.1% from a year earlier. That's down from 2.6% annualized growth in Q4 2022. Powell and others have pointed to the strong labor market as evidence we may still avoid a recession. The history of inflation battles suggests a recession remains likely, although the odds are increasing that it may not happen until next year.

If second- and third-quarter GDP numbers stay positive, that will be reason for optimism. If they turn negative, it will not be a major surprise. The stock market is aware an economic recession remains a strong possibility, and a good chunk of that risk is reflected in current valuations.

Equities tend to perform quite well after the Fed stops hiking. In the last 50 years, there were 10 different cycles in which the Fed raised rates meaningfully. In eight of the 10, the S&P 500 was higher one year after the final rate increase. Even including the two outliers, the S&P averaged a 14.3% return. In the six months after the final Fed hike, the S&P was positive six of the 10 times with average returns of 5.2%, according to data compiled by Ryan Detrick of Carson Investment Research.

As for bonds, U.S. Treasury yields tend to peak shortly before the final Fed hike and drop in the months afterward. The yield curve presently is very much inverted, meaning short-term bonds offer higher rates than longer-term bonds. On its surface, that would seem like incentive to invest in short-dated maturities. Given interest rates will almost certainly fall over the next 12-18 months, however, it's probably a good time to lock in current yields for longer.

Interestingly, it's short-term yields that fall the most whether it's six months, 12 months, or two years after the last Fed hike. Intermediate and longer-dated bond yields fall by smaller margins. In terms of specific fixed income categories, investment-grade corporate bonds averaged an 11.8% total return in the 12 months following the last three "final Fed hikes" in 2000, 2006, and 2018.

It's important to note bond yields have often decreased in anticipation of more friendly Fed policy well before we get an official cut to the Fed Funds Rate. Mortgage rates will also come down, which will slowly ease the burden of higher home prices combined with lower affordability.

Both the Fed's own forecasts and market futures indicate interest rates will move steadily lower in the years ahead, though the Fed has a history of pivoting on short notice. Regardless of when the cuts begin, financial markets are already looking ahead to the next chapter. Investors should too.

Ben Marks is chief investment officer at Marks Group Wealth Management in Minnetonka. He can be reached at ben.marks@marksgroup.com. Brett Angel is a senior wealth adviser at the firm.