Driving the most recent selloff were investor concerns that the Federal Reserve will hike interest rates four—even five—times this year along with potential balance-sheet reduction. And though the Fed has made its new money-tightening policy more clear, it’s still a complex one to implement, and the following challenges in particular could mean policy mistakes and increased market volatility:

• A ways to go for rising rates: Historically, higher inflation has tended to correlate with higher Treasury yields, but that relationship appears broken today. In fact, rarely in the last 60 years have Treasury rates been so disconnected from inflation as they are now. This gap has a couple of implications: Not only has it created deeply negative real, or inflation-adjusted, rates that penalize savers and reward risktakers, it also implies that the run-up in yields so far is only about halfway done and that the Fed will need to play catch-up on raising rates in an effort to normalize policy.
• Our analysis shows there’s room for the 10-year Treasury yield to rise further. Specifically, Morgan Stanley strategists expect it to reach 2.3% by year-end, and this could deliver another 5%-7% hit to equity markets, as rising rates typically lower stock valuations, all else equal.

• A massive balance sheet to wind down: Managing rate hikes is just part of the Fed’s tall task. The central bank is also considering simultaneously reducing its massive portfolio. Recall that, as part of the ambitious bond-buying program it rolled out during the pandemic-induced 2020 recession, the Fed more than doubled its assets—to nearly $8.8 trillion over the past two years.
• The resulting boost of financial liquidity has directly correlated with an expansion of price/earnings multiples within the S&P 500. But now, the Fed has an enormous balance sheet to unwind—and little experience doing so at such a scale. If it does this too quickly, markets could see higher volatility, much like the turbulence that hit investors in December 2018 amid tightening financial conditions and worries that the Fed was moving too fast.

• Geopolitical risks: Last, the Fed is also facing emerging geopolitical risks that have implications for inflation. Oil prices climbed to their seven-year high last week amid rising tensions around the Russia-Ukraine conflict. Sanctions or military engagements could drive global energy prices higher, further complicating the Fed’s job and consumer expectations.
• Also, with China now facing down its own Omicron coronavirus wave with another zero-tolerance policy, the potential for renewed global supply-chain disruptions is once again a concern.

The Fed will need to navigate these developments while making multiple and interdependent decisions on the timing, size and mix of policy choices. The challenge for investors will be to consider the growing list of uncertainties around Fed strategy and to adjust their portfolios appropriately. We are not convinced that the recent downturn in markets fully discounts the risks, and we encourage investors to keep an eye on policy guidance, inflation drivers, consumer confidence levels and interest rates.

Consider leaning defensive in both stocks and bonds, building cash for opportunistic deployment later.