Stock markets had been trading steadily near all time highs through most of November. However, during the middle part of the month, a sell-off started to take hold. It wasn’t broad based, but certain areas started to show material weakness behind the scenes. Small cap stocks, for example, as measured by the Russell 2000 or S&P 600, are down 13.30% and 10.60%, respectively, from an early November peak. Large-cap stocks, represented by the S&P 500, are not down nearly as much, but have fallen close to 4% over the last week. While it’s hard to pinpoint an exact reason for market fluctuations, the increased volatility has coincided with the Federal Reserve unveiling plans for their first interest rate hike in 2022.
Interest rate hikes are coming
Last month, we detailed that the market was expecting the Fed to start raising interest rates sooner than what most forecasts were calling for. The Federal Reserve meeting and commentary last week from Chairman Jay Powell confirmed the markets view, and market expectations for a rate hike in March 2022 are up to 43% from 19% one month ago. And current consensus expects the Federal Reserve’s interest rate to be 1% by the end of 2022 (it’s currently 0%). So whether it’s in March of next year or later on, the market’s (and fed’s) message is clear: interest rate hikes are coming.
Will interest rates hikes crash stocks?
Will these interest rate hikes derail stocks in 2022? Well, first we should probably define “derail” before we go ahead and use the term loosely. Derail would imply that global stock markets put in a meaningful top and fall 20% from their highs (the classic definition of a bear market). Furthermore, it would imply that the chances of restarting an uptrend shortly after such a decline are low. By that definition we certainly do not expect interest rate increases next year to be a catalyst for a 20% decline in the market.
For one, such declines are often triggered by unexpected catalysts. The market, in this case, is aware of the probability that rates will climb next year. Secondly, the rate of increase is still very low by historical standards. The Fed could raise rates four times next year and still only get to a 1% interest rate. For perspective, in the 1970s-1980s, the Fed would whip interest rates by 0.50-2.0% at a time (and sometimes as much as 3-4%). Interest rate policy was much less volatile in the 1990s-2000, but the Fed would still adjust them by 0.50-0.75% at a time.
Since 2008, the Fed has been committed to “lower for longer” interest rate policy. And when they did finally raise rates for the first time after the 2008 Great Financial Crisis, they went very slowly and modestly, beginning in 2015 with a 0.25% increase. They’ll use the same playbook this time around.
What happened last time
From December 2015-December 2018, the Fed raised interest rates a total of nine times, 0.25% at a time, to an interest rate high of 2.50%. Here is how the S&P 500 performed during that period, as represented by Vanguard’s S&P 500 ETF (VOO):
The S&P 500 rose more than 30% during that cycle, and was particularly steady during 2016-2017 as the rate hike cycle was getting underway. It wasn’t until the rate had increased five times, to 1.50% in December 2017, that things started to go sideways for stocks (2018 was a down year for the S&P 500). No two rate cycles are the exact same but at least in this case we can look at what happened following the first rate increases in the mid 2010’s and see that stocks did just fine.
Pay attention to the yield curve
A better predictor of when stocks may be preparing for a meaningful move lower is the yield curve, or the spread between 2-year Treasury notes and 10-year Treasury bonds. Typically, long term Treasuries have higher yields than short term Treasuries. This results in a yield curve that slopes upwards and to the right. An upward sloping yield curve is associated with economic growth and a bull market for stocks. When the yield curve inverts, that is when short term Treasuries have higher yields than long term Treasuries, it is a leading indicator of a recession and bear market for stocks.
Since the 1970’s, every single time the yield curve has inverted, a recession has followed, typically within 12 months. This makes it a great leading indicator for the stock market. The last inversion occurred in August 2019, seven months before the pandemic induced recession and Covid crash in stocks. Currently the yield curve looks like this:
It is sloping in the right direction, but the spread between 2-year Treasuries and 10-year Treasuries is less than 1%, down from a spread of 1.29% just two months ago. This spread is important because if it goes negative, that will, by definition, create an inverted yield curve (2 year yields > 10 year yields). Cam Hui, CFA, founder of humblestudentsofthemarket.com wrote a great post suggesting that, based on recently communicated fed policy and current market probabilities for future rate hikes, the yield curve could invert sometime in 2023. That forecast would take a recession or bear market off the table for 2022.
Inverted yield curves don’t automatically crush stocks
Even if the yield curve inverts earlier, such as in the second half of 2022, it doesn’t spell an immediate doom for stocks. The inverted yield curve is a leading indicator because it typically shows up well ahead of an economic recession or material market weakness. In fact, after the yield curve first inverted in August 2019, the S&P 500 rallied more than 10% through the end of that year:
The fact that the yield curve has flattened a little bit recently can likely be attributed to two main reasons:
- The fed, through their rate hikes, is trying to bring down inflation. An expected consequence is that they also slow down the economy a little bit
- Growth expectations have readjusted a little lower as policy makers continue to struggle with their handling of the pandemic.
And here are two reasons neither of these is likely to result in an imminent yield curve inversion or recession:
- The labor market remains very tight which is helping to boost wages. This suggests we could be transitioning from a period of persistently low inflation to a period of inflation that is more in line with historical averages.
- The fed is going to move carefully and slowly. The short-end of the curve that is crucial to an inversion is very sensitive to interest rate policy. It will likely take the Fed an entire year just to move their interest rate up to 1%. And if they see lower inflation early on, sense panic in the stock market, or uncertainty in the economy, they could be quick to stop raising rates all together.
The market could surprise to the upside
Heading into 2022 there are jitters that the stock market is bracing for a sell-off. The narrative goes like this: a renewed Covid surge coupled with a tightening Fed is going to create problems for stocks. While this could be true, the evidence doesn’t necessarily bear out the claim. The market has dealt with Covid for the better part of two years and, barring a terribly unpopular policy response (i.e. US lockdowns), it’s unlikely the market views this recent wave as anything more than temporary (similar to the Delta wave).
As for the interest rate side of the equation, yes the Fed is tightening. However, they’ve been careful to telegraph their moves to the market and not catch investors off guard. In addition, they are moving slowly and appear very conscious of the market’s reaction. Lastly, the yield curve, which is the best forecaster of market weakness, is currently upward sloping. When and if it inverts, it would serve as a warning sign to be taken far more seriously than any dire headlines you may be reading in the financial media today.