Wednesday’s inflation report sent an unmistakable message to Wall Street: the Federal Reserve’s fight against inflation is far from over.
September’s Consumer Price Index (CPI) rose 3.7% year over year, accelerating from 3.4% in August and exceeding economists’ expectations of 3.6%. The market reaction was swift. The Nasdaq fell 1.9%, the S&P 500 declined 1.1%, and small-cap stocks suffered a similarly sharp selloff.
The catalyst was straightforward. Higher inflation increases the likelihood that the Fed will maintain restrictive monetary policy—or raise interest rates further—to bring inflation back toward its 2% target.
But at Atlas Analytics, we believe the market is missing a bigger story.
The era of near-zero interest rates is over, and investors have yet to fully adjust to what comes next.
The chart above should look familiar to longtime readers. We first published it on February 1 of this year, when we forecast that the Federal Reserve would embark on another rate-hiking cycle rather than deliver the cuts anticipated by consensus.
Eight months later, our conviction remains unchanged. We continue to expect the federal funds rate to approach 5% over the medium term, substantially above the Fed’s projected path.
Higher for Longer: A New Interest Rate Reality
We’ve been anticipating persistent inflation and a more hawkish Federal Reserve for some time.
Our thesis is not simply that the Fed might raise rates again this year. Rather, we believe investors have become accustomed to an interest-rate environment that was historically exceptional.
Following the 2008 financial crisis, the United States experienced an extraordinary period of monetary accommodation. Interest rates hovered near zero, quantitative easing suppressed long-term borrowing costs, and investors became accustomed to cheap capital.
But zero interest rates were the anomaly, not the norm.
For much of modern American economic history, nominal interest rates of 4–5% would hardly have been considered unusual. We believe the economy may be returning to something closer to that historical reality.
Our expectation is that the federal funds rate will remain closer to 5% over the medium term, rather than returning to the near-zero levels that characterized much of the 2010s.
Structural forces, including persistent fiscal deficits, changing global supply chains, and a potentially higher neutral rate of interest, could reinforce this environment.
This does not mean rates must rise indefinitely. It means that even after the Fed finishes tightening, the destination may be considerably higher than investors once expected.
And that has profound implications for asset valuations.
What Does This Mean for Equities?
The relationship between interest rates and equities is often understood through the equity risk premium (ERP): the additional return investors demand for owning stocks rather than relatively safe government bonds.
As Treasury yields rise, investors can earn higher returns without assuming equity risk. All else equal, this reduces the relative attractiveness of stocks and places downward pressure on valuations.
The relationship is imperfect. Corporate earnings growth and changes in risk appetite can offset higher discount rates. But the underlying mathematics is difficult to escape.
Growth companies are particularly sensitive because a disproportionate share of their expected value comes from earnings projected far into the future. Higher discount rates reduce the present value of those earnings.
This is especially important for technology companies trading at elevated multiples.
Conversely, value-oriented businesses with established cash flows and more conservative valuations may become relatively attractive.
We therefore anticipate a period of increasing differentiation across equities, with expensive growth stocks facing valuation pressure and selected value opportunities potentially outperforming.
The recent selloff in technology and small-cap equities may be an early illustration of this repricing.
Where We See Opportunity: Four ETF Convictions
Our macroeconomic outlook informs four distinct investment views: bearish on technology and energy, and bullish on long-duration Treasuries and communication services.
Short XLK: Technology Has Priced In Too Much Optimism
We’ve been skeptical of elevated technology valuations for some time.
The AI revolution is real, and many leading technology companies are exceptionally profitable. But a transformative technology does not automatically make every investment attractive at every price.
In our view, investors have extrapolated extraordinary growth expectations too far into the future, leaving valuations vulnerable to even modest disappointments.
As interest rates remain elevated, the discount applied to those future earnings becomes increasingly consequential.
We expect this pressure to weigh on the Technology Select Sector SPDR Fund (XLK), particularly where valuations already assume years of exceptional growth.
Smaller-cap companies may face additional pressure from higher borrowing costs and refinancing risks, although their valuations and balance sheets vary considerably.
Our concern isn’t the quality of the technology. It’s that investors are over paying for it.
Long TLT: Treasury Yields May Have Overshot
Our bullish view on long-duration Treasuries may initially appear contradictory. We were after all short long-bonds for most of last year.
If interest rates are going to remain higher for longer, why favor the iShares 20+ Year Treasury Bond ETF (TLT), which typically loses value when long-term yields rise?
The answer is that markets can overshoot.
Economist Rudiger Dornbusch famously demonstrated how exchange rates can overshoot their long-run equilibrium following monetary shocks. While his original model concerned foreign exchange, the underlying intuition applies more broadly: financial prices can move beyond levels ultimately justified by fundamentals.
We believe something similar may be occurring in the Treasury market.
Long-term yields reflect not only expectations for future Fed policy but also inflation expectations, real interest rates, and the term premium investors demand for holding longer-maturity bonds.
Our view is that the recent rise in long-term yields may have gone too far, even accounting for a structurally higher federal funds rate.
This distinction is critical. We can believe the Fed will remain hawkish while simultaneously believing long-term Treasury bonds have become oversold.
TLT could certainly decline further, particularly if inflation remains stubborn or Treasury risk premiums continue rising. But we see an increasingly attractive opportunity for a reversal in long-duration yields as markets reassess their longer-term expectations.
Long XLC: AI Disruption Fears May Be Overdone
While we’re cautious on technology valuations broadly, we see a more attractive opportunity in the Communication Services Select Sector SPDR Fund (XLC).
The fund is heavily concentrated in Alphabet and Meta, two companies facing considerable uncertainty surrounding artificial intelligence.
Investors worry that generative AI and alternative search platforms could erode Google’s dominance in search, while increasing competition and capital expenditure could pressure Meta’s profitability.
These are legitimate concerns. But we believe the market may be overestimating the speed and magnitude of the disruption.
Alphabet and Meta retain enormous advantages in distribution, advertising infrastructure, user networks, and financial resources. Both also have opportunities to deploy AI to improve their existing products and monetization.
Importantly, we see a distinction between companies whose valuations depend on extraordinary future AI growth and established businesses whose current earnings may be undervalued because of fears surrounding AI.
We believe XLC offers a compelling relative-value opportunity, provided its earnings durability remains intact.
Short XLE: Energy’s Geopolitical Premium Looks Vulnerable
Our bearish outlook on the Energy Select Sector SPDR Fund (XLE) is driven less by conventional valuation concerns and more by commodity-price expectations.
The conflict involving Iran and uncertainty surrounding Russian energy supplies have contributed to elevated oil and gasoline prices. Indeed, gasoline prices rose 9.1% in September alone, accounting for more than half of the monthly increase in headline CPI.
Energy companies have benefited from this environment, and some may be reasonably valued based on prevailing commodity prices.
But that is precisely the risk.
If geopolitical tensions ease, supply disruptions moderate, or arrangements involving Russian energy exports improve market availability, today’s elevated prices could reverse relatively quickly.
In that scenario, energy-sector earnings expectations could weaken, putting downward pressure on XLE.
We acknowledge that further geopolitical escalation could produce the opposite outcome. Nevertheless, we believe the balance of risks increasingly favors a normalization in energy prices rather than a sustained continuation of the recent surge.
The Bigger Picture: Capital Is No Longer Free
For more than a decade, investors operated in an environment where capital was exceptionally cheap.
Low discount rates supported elevated valuations, encouraged speculation, and rewarded businesses whose profits lay far in the future.
That environment is changing.
A world of persistently higher interest rates places greater importance on current earnings, sustainable cash flows, balance-sheet strength, and valuation discipline.
It also creates opportunities.
Some assets remain priced for a return to cheap money. Others, including long-duration Treasuries, may have already overreacted to the prospect of permanently higher rates.
At Atlas Analytics, we believe investors should distinguish between the direction of monetary policy and the extent to which its consequences are already reflected in market prices.
Our view is that the Fed will remain more hawkish than many market participants anticipate. But that doesn’t mean every asset exposed to higher rates is necessarily a bad investment.
The next phase of the market will not simply reward those who correctly predict interest rates. It will reward those who identify where expectations have gone too far.
And in a world where the cost of capital matters again, valuation discipline may be more important than ever.
Atlas Analytics provides independent macroeconomic research and forecasting. The views expressed are forward-looking opinions as of publication and are subject to change. ETF positions discussed represent directional market views and are not individualized investment recommendations. All investments, including short positions and long-duration bonds, involve risk.