The S&P 500 index had its best performance of 2022, year-to-date, last week. From the lows Monday, the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) exchange-traded fund (ETF) surged. To put a number on it, SPY stock jumped 7% over a four-day period.
This was unexpected, as it came amid a series of seemingly negative developments for the market. For one, the conflict between Russia and Ukraine drags on with little sign of an imminent breakthrough that would resolve its associated political or economic risks.
For another, the Federal Reserve formally kicked off its rate hiking cycle. It increased its target rate by 25 basis points on Wednesday and signaled that there will be many more hikes in the future. Currently, the credit market is projecting roughly eight hikes in total over the next two years.
Generally, investors tend to be nervous about higher interest rates. When the Fed tightens the money supply, it often leads to an economic slowdown. And indeed, the credit market is now heading toward inversion, which has an almost perfect track record of predicting recessions and, thus, stock market declines. As such, traders should be careful with SPY and other such index ETFs here. Last week’s rally in no way guarantees that a bottom is in.
Powell Admits Inflation Isn’t Transitory
Powell said that the situation in Ukraine could cause the economy to slow on its own. Regardless, he added this ominous warning for the stock market bulls on Wednesday in his press conference following the rate hike decision.
“But inflation is far above our target. And, you know, the help we’ve been expecting, and other forecasters have been expecting, from supply-side improvement, labor-force participation, bottlenecks, all those things getting better — it hasn’t come. And so we’re looking now to using our tools to restore price stability. And we’re committed to doing that.”
The Federal Reserve chair rarely gets directly to the point. Former chairman Alan Greenspan, for example, was notorious for speaking in oblique impenetrable language. By this standard, Powell’s above comment is rather direct. The Fed was looking for inflation to start to rein itself in as the pandemic-induced shocks started to fade from the economic landscape.
However, as Powell bluntly noted, that anticipated help simply “hasn’t come.” So now the Fed has to take matters into its own hands with a sharper policy response to get inflation under control. Just as Fed stimulus helped power the SPY ETF to record heights, the removal of that stimulus could spell major trouble ahead.
The Inverted Yield Curve and SPY Stock
The interest rate curve has been making big moves amid the rate hike discussion. The short-end of the curve has surged as traders price in the flood of incoming rate hikes. Meanwhile, at the back end of the curve, yields are barely moving at all.
Normally, a steeper yield curve is associated with a healthy economy. The price of credit increases as demand is high. Folks are rushing to borrow money to buy houses, cars and other big ticket items. By contrast, a flatter yield curve, such as we have now, is associated with economic sluggishness.
Since 1955, on every occasion except one, when the yield curve has inverted, it has been quickly followed by an economic recession. The Fed concluded as much in a 2018 study. This played out again subsequently to that 2018 report; the curve inverted in 2019 and the economy tipped into a recession in 2020.
While the yield curve hasn’t fully inverted yet, parts of it have started to in recent weeks. This will exert downward pressure on bank earnings, among other pieces of the economy.
Simply put, the credit market is expressing concern that the Fed will raise rates too aggressively. That could lead the economy into a recession. When the yield curve inverts, we almost always get a recession and bear market in stocks. It’s dangerous to bet that this time will be different.
SPY Stock Verdict
It’s tempting to look at the big rally since the Fed rate hike and think the danger has passed. After all, if the market absorbed the first hike so well, maybe the rate hikes won’t be such a large concern after all.
However, that’s not the most likely outcome. Throughout the years, the Fed has been very deliberate in terms of achieving its policy goals. And the Fed has a history of hiking past the point where it would seem necessary. We’ve seen big market busts in 2001 and 2008, among other occasions, when monetary conditions arguably got too tight.
Is the Fed going to go too far this time in terms of tightening monetary conditions into a rapidly weakening economy? Only time will tell. However, we do know that Powell continued hiking rates in December 2018 after markets had already dropped sharply, ultimately leading to a 20% peak-to-trough decline in SPY.
It seems unlikely that the market will ultimately bottom at a less than 15% decline from its recent highs in the face of up to nine rate hikes, spiraling inflation, and rising geopolitical uncertainty. This may be the one time bulls get lucky and avoid a more significant drawdown. However, during rate hike cycles, we usually see bear markets by the end of them. And to get to that threshold, SPY stock still has more downside ahead.
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.