The Fed is widely expected to raise interest rate or more accurately the Fed funds rate by 50 basis point (bp) at its May meeting. At least one more 50 bp and several 25 bp hikes are forecasted to rein in inflation, which has hit the highest in 40 years, with US consumer price index (CPI) at 8.5%. Additionally, a rapid reduction of the Fed's $8.9 trillion balance sheet is expected, trimming to a tune of $95 billion per month.
J Powell photo credits: Samuel Corum / Getty Images
Markets Longer Term
Historical data compiled by Fisher Investments shows that stock markets, using $S&P 500(.SPX)$ as the proxy actually performed better, not worse during rate hike cycles. From table below, in 9 rate hike periods since the 1970s, average annualized S&P 500 total return is 11.8%, even slightly above the historical returns of the index at 10.5% (1957 to 2021). Median total return is 7.5%. Only once in Mar to Jul 1984 was there a negative return of -9.0%.
source: Fisher Investments
Further from the table above, it does not matter the percentage change (PPT Change) or duration in months of the rate hike period, markets remain generally bullish. The only 3 instances where a Bear Market start (stock prices dropped 20% or more from the top) is when there is inverted yield curves (shorter term yield higher than longer term). But just like in 2020 after covid-19 induced crash and recovery, price rebounded strongly and returns are huge, ranging from 7.1 to 32.5%.
Digging Deeper
To understand reasons for the outperformance , a chart correlating Fed funds rate (black line) and 2-year forward return S&P 500 (green/red areas) might provide clues.
It shows that the beginning of a rate hike cycle (black line rising) is often followed by very strong two-year returns (green areas). This could be because the rate hikes are initiated due to very strong or overheating economy. The exception to this is in 1970-1974 where the economy was weak but inflation was red-hot.
source: Insider Opportunities
What about in 2022?
The US economy has been strong post pandemic and in 2021, and only in first quarter 2022 did we see a slight dip. Thus, the likelihood is rising rates would not impact the stock markets negatively, similar to the previous cycles.
What the Feds need to be careful is late in the cycle, where rates are raised too much, inducing a recession. This tipping point would cause the stock markets to decline massively by up to 40%, as happened in 2001-2002 and 2008-2009.
Markets Short Term
What about shorter term, how would it perform in days to weeks before and after the FOMC announcement?
University professors Andreas Neuhierl and Michael Weber studied this on $S&P 500(.SPX)$ and their findings (see chart below) showed that if Fed made surprisingly negative announcement, starting from about –25 days out, price would track lower in the lead up to FOMC. The opposite is true for surprising positive announcement., price would track higher prior to FOMC. Post rate announcement however, after +15 or more days, stock prices would drift higher by between +2 to +4%.
source: Neuhierl and Weber (University Norte dame and Chicago Booth)
With Fed Chair J Powell, the news conference after the FOMC meeting is where the positive or negative surprise might happen. However, as shown by the study, either case, after 15 or more days, price will be positive, irrespectively of the temporary dips before or post announcements.
Tank or Fly in Long and Short Term?
It seems Markets would likely fly and not tank, in the longer and shorter term, especially at the start of the hike cycle. Only if the rate hikes are overdone, triggering a recession would the returns be negative.
While past patterns might not be indicative of future price performance, we could study the likelihoods of each scenario, be better informed and trade with more confidence!
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