Stocks continue to experience big swings so far in 2022. The main reason for the volatility is the fast change in interest rate expectations. Just three months ago, the market was debating if the Fed would raise the federal funds rate from 0% to 0.25% by June. Today, the market now expects that same interest rate will be 1% or higher by June. This equates to four interest rate hikes by June versus prior expectations of one or maybe two. From the market’s perspective, this is a swift change in the expected path of interest rate hikes that has resulted in an equally fast repricing of stocks.
Momentum for more hikes
Back in November, as momentum started building for a possible March hike (from June), we wrote the following:
You can see there is clearly momentum building for an interest rate hike. And these expectations are important because the Fed has a history of delivering what the market is expecting. So in a way the interest rate hikes can become self-fulfilling; as the market expects hikes sooner and sooner, those hikes become more and more likely.
–The fed may raise rates sooner than expected (11/15/21)
The self-fulfilling dynamic we highlighted back then has continued to play out, and is the main reason the Fed is likely to increase rates much more aggressively than previously expected. In other words, because the market expects the Fed to act more aggressively, it enables the Fed to do just that.
If we look at December 2022 interest rate expectation from one month ago, the market was expecting 3-4 hikes this year. Now, it’s expecting 7-8:
How is the market handling this?
As the graph shows, there’s essentially been a doubling of interest rate expectations in just one month. That’s not only a big absolute change in expectations (from 3-4 hikes to 7-8) but also a very fast change. A gradual change in expectations may not have caused as much volatility. This is likely the main cause of angst in the market right now, and a big reason why the S&P 500 has declined by 6.50% over the last month:
This is both good news and bad news. The bad news is obvious… who likes losing 6.50% in a month? The good news is that this decline is pricing in a lot of negativity. We reiterate this whenever we can: markets are forward looking. If rising interest rates are expected to slow down the economy and be a negative for the market tomorrow, it prices that in today.
So what’s the good news?
In essence, this reduces the potential negative reaction we might see in the market once the Fed actually starts raising rates. To illustrate this point, take a look at the following table showing how the S&P 500 has performed in the last 40 years following the first rate hike at the start of a rate hiking cycle:
The first few months immediately after a rate hike can be a bit mixed, but 6-12 month returns are very strong, on average.
We could refer to this potential set up as a “sell the rumor, buy the news” opportunity. That occurs when there is a decline ahead of a known risk event, in this case the Fed hiking rates in March, and a potential rally thereafter. Perhaps the most famous “sell the rumor, buy the news” event happened when stocks sold off 3% ahead of the 2016 election, only to then rally more than 5% immediately after President Trump won election.
It wouldn’t be a surprise to see stocks continue to experience a lot of volatility over the next few weeks. In fact, that’s probably the odds on bet at this point. But looking out 6-12 months, it’s hard not to be optimistic on the market, especially as “the crowd” becomes more pessimistic. Keep in mind, as we wrote last month, the S&P 500 could fall to 4,143 (~6% below current prices), and still be in line with average yearly pullbacks (14% since 1980). Furthermore, the market has a history of rallying off of its intra-year low.
If the market does move lower over the coming weeks we plan to treat it as a buying opportunity and believe it could end up being the low for the year.
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