Will Fed rate hikes crush the stock market? Here’s why speed matters

With the Federal Reserve all but certain to start raising interest rates in March, market forecasters were quick to reassure investors that history shows stocks tend to do well as policymakers s engage in a cycle of monetary policy tightening.

But like most things related to markets, there is more to the story.

It turns out that when the Fed moves quickly to raise rates, as it signaled it was prepared to do in a scramble to contain US inflation at its highest since the early 1980s, performance at The stock market’s short term hasn’t been quite as stellar, said Ed Clissold, chief US strategist at Ned Davis Research.

“It’s intuitive that the job of the Fed, when it starts raising rates, is to pull out the punch bowl before the party gets too hot,” he said in an interview Thursday. It should come as no surprise, then, that “the faster they were, the more the markets took notice.”

Clissold and Thanh Nguyen, senior quantitative analyst at NDR, detailed the difference between market performance in “fast” and “slow” cycles in a Feb. 9 note. They found that within a year of the initial rate increase, the S&P 500 SPX,
increased by an average of 10.5% in slow cycles compared to an average decrease of 2.7% in fast cycles (see graph below).

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The median gain in the first year of a slow cycle was 13.4% versus 2.4% for fast cycles. The median maximum drawdown in slow cycles was 11%, compared to 12.1% for fast cycles.

Overall, “fast cycle yield and decline statistics are consistent with choppy conditions, but not necessarily a major bear market,” Clissold and Nguyen wrote.

So how fast is fast? It’s a bit subjective, Clissold told MarketWatch, but past cycles have shifted relatively clearly between the two categories. The NDR expects four or more rate hikes in the Fed’s seven remaining policy meetings in 2022, alongside the start of a reduction in the size of the central bank’s balance sheet – a pace that would clearly place the cycle in the “fast” category.

Some Fed watchers see a faster pace than that, and fed funds futures traders have increasingly priced in the prospect that policymakers will kick off the cycle with a half-point rate hike. rather than the typical quarter point, or 25 basis point, move.

The market’s assessment of an aggressive rate hike scenario seems reasonable given inflation, said Lauren Goodwin, economist and portfolio strategist at New York Life Investments.

That said, it’s worth remembering that the market and the Fed itself, via the central bank’s so-called point forecast for benchmark interest rates, has been relatively poor at predicting the actual rate outcome, she noted in a phone interview.

This is not a criticism, she said. Rather, it simply reflects how difficult it is to make accurate rate predictions. New York Life Investments, for its part, expects four quarter-point rate increases in 2022, possibly early.

The fact, she said, is that there has already been significant volatility around rate expectations and, moreover, that is likely to continue as the data comes in. This could lead to greater volatility in the rates market and the yield curve, which has flattened considerably since the start of the year as short-term rates have risen sharply in anticipation of Fed tightening while longer-term yields rose less sharply.

The yield curve is considered an important indicator in itself. An inversion of the curve, especially when the 2-year or shorter-maturity yields exceed the 10-year yield, has been a reliable indicator of recession.

That hasn’t happened yet, but the rapid flattening of the curve could reflect fears that aggressive Fed tightening could push the economy into recession, some analysts said. Others offer a more benign interpretation, with the flattening reflecting expectations that a quick Fed response will help fight inflation without requiring rates to skyrocket.

At first glance, the latter scenario would appear to favor stocks of companies tied to the business cycle, particularly those that are able to pass on rising costs and manage rising costs of capital, Goodwin said. In terms of asset class, that would tend to favor value stocks over growth stocks, she said.

But it is not that simple. “It really depends on the company and their capital structure and how competitive they are in that kind of environment,” she said, noting that some tech stocks have done very well in an environment that no longer seems promote growth, while others have suffered.

It gives a more “business by business” image that favors active managers, Goodwin said.

This is all part of a “mid-cycle” environment. Economic growth remains healthy, which is positive for equities, but growth should only slow from here, she said, making “earnings and earnings quality particularly important.”

This will change when there are clearer signs that the economy is simply slowing down, i.e. when broader asset class considerations play a bigger role in determining outcomes for investors, she said.

US markets will be closed on Monday for the Presidents Day holiday. Meanwhile, investors like Fed officials will remain glued to inflation data, while monitoring developments around Ukraine as US officials warn of the threat of a Russian invasion.

Ukraine-related jitters have been partly blamed on the stock market’s stumble over the past week, with the Dow Jones Industrial Average DJIA,
down 1.9%, while the S&P 500 fell 1.6% and the Nasdaq Composite COMP,
lost 1.2%.

Friday will bring the Fed’s favorite reading on price pressures with the release of the January Personal Consumption and Expenditure, or PCE, inflation reading. February’s final version of the University of Michigan’s five-year consumer inflation expectations is also due Friday.

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