S&P 500: Fed Risks Market Plunge With Aggressive Rate Hikes

Over the past few days, traders have focused intently on the Russia and Ukraine situation. It seems, every jump in indexes and exchange-traded funds (ETFs) such as the SPDR S&P 500 ETF (NYSEARCA:SPY) stock is related to Putin’s latest military movements.

ETF Investment index funds concept with letter wooden blocks and lots of different currencies, ETFs to buy
Source: Eviart / Shutterstock.com

And, to be sure, it’s of crucial importance what ends up happening with that geopolitical situation. Here are seven stocks with Russia and Ukraine exposure to steer clear of as long as the crisis persists. However, that’s not the actual key issue that has the most weight over the intermediate outlook for SPY stock and the other major American market indexes. Rather, the crux of the matter is interest rates.

Interest Rates Are A Major Problem

Interest rates have been spiking for a little while now. And I’d argue that this is precisely why certain areas of the market such as speculative growth stocks, meme names, and Cathie Wood’s ARK Innovation ETF (NYSEARCA:ARKK) have fared particularly poorly. As capital starts to come out of the system, the assets with the least fundamental underpinning tend to suffer the most.

Why would this be? Because tech stocks have inherently become a bet on lower interest rates. Over the past few years, investors have taken up the mindset that with interest rates at zero, they should buy as much duration as possible. Duration, in this sense, meaning future cash flows as opposed to profits or dividends today.

As Rates Rise, Near-Term Fundamentals Matter Again

In a world where interest rates are zero, the value of a future dollar earned by Datadog (NASDAQ:DDOG), Snowflake (NYSE:SNOW), or Shopify (NYSE:SHOP) in 2035 is not too much less than a dollar earned by Chevron (NYSE:CVX) today. People are willing to pay exponentially more for a growth security when interest rates are close to zero.

If you run a financial model on a stock, the discount rate is a huge factor in the fair value of a security. Up until not too long ago, we typically used a 10% discount rate, meaning future cash flows were depreciated by 10% per year as you go out into the future. A company with no current profits or cash flows has not too much value in this sort of scenario, because by the time it (hopefully) starts generating profits, the future value on that profit is minimal.

However, in a zero interest rate world, people have cut their discount rates dramatically. After all, if capital is free, you just want to own the biggest fastest-growing tech companies out there, regardless of valuation. And that was very much reflected in valuations until around November of 2021.

The Rate Rally Turns Into A Frenzy

However, this spike switched into overdrive over the past few weeks. Also, and this of of central importance — the spike is in short-term interest rates. Long-term interest rates are moving more slowly, which might give you a false sense of security.

But no, we’re seeing some wild moves — think five standard deviation sort of stuff — over the past couple of weeks.

It started with the Federal Reserve’s most recent interest rate decision. They elected not to raise rates. However, the post-decision press conference left the door open to a surprise 50 basis point rate hike, instead of the expected 25 pointer, in March.

That’s why the market rallied initially but then sold off sharply following the Fed decision. Since then, Fed members such as James Bullard have added fuel to the fire, suggesting that the bank will act aggressively and imminently to stamp out inflation.

And the interest rates drama was just getting started. Europe has added to the panic. The Brits raised interest rates, despite mixed underlying economic conditions. Analysts pointed to out-of-control inflation due to Britain’s electricity crisis as forcing their hand.

Following that up, the European Central Bank’s Christine Lagarde did a terrible job of communicating with the public. While the ECB didn’t hike rates immediately, Lagarde clumsily signaled toward much more hawkish policy going forward. This caught the market off-guard and caused the single biggest spike in European short-term interest rates in the past decade.

Volatility Is Near for SPY Stock

The American credit markets are now pricing in approximately seven rate hikes over the next two years. It seems unlikely that the stock market will be able to withstand that sort of bold rate-hiking campaign without substantial collateral damage. Just removing further stimulus in recent months has helped trigger a brutal sell-off in the technology sector.

It’s also worth remembering that the credit markets are substantially larger than the equity markets in terms of the total amount of assets at there. When you start seeing wild activity in bonds, look out, since volatility is surely on the way. When credit markets broke in 2007, for example, we all know what happened to the stock market not long after.

Bottom Line on SPY Stock

Is the Fed going to hike the economy straight into a recession and cause a big market decline? Not intentionally. But don’t forget that Mr. Powell pushed through a controversial rate hike in late 2018 that helped cause a 20% drop in the S&P 500 before he finally stopped that rate increase cycle.

Like in late 2018, the Fed may push too far, and only let up after the stock market indexes drop dramatically. For now, traders in SPY stock and other such market ETFs must pay close attention to the bond markets. Until they settle down, stocks will be at risk of a sudden decline.

On the date of publication, Ian Bezek did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a sizable New York City-based hedge fund. You can reach him on Twitter at @irbezek.


Article printed from InvestorPlace Media, https://investorplace.com/2022/02/spy-stock-fed-risks-market-plunge-with-aggressive-rate-hikes/.

©2022 InvestorPlace Media, LLC