The Fed reveals its 2022 playbook … how accurate are historical consensus estimates about rate hikes? … the often-overlooked variable that could predict where stocks end up in 2022
On Wednesday, the Fed showed us its cards:
Seven rate hikes for 2022.
That shakes out to a fed funds rate of 1.9% come December. This figure represents the median projection of the Federal Open Market Committee (FOMC) members, according to Wednesday’s release.
And what does the market think about where rates will be?
If we go by the CME Group’s FedWatch Tool, as I write, the highest probability range for where the fed funds rate will be at the December 2022 Fed meeting is 2.0% – 2.25%.
So, a bit higher than the median Fed projection, but roughly in line.
What are the implications of such a hike for stocks?
To answer this, let’s evaluate two things:
One, how accurate consensus estimates have been about rate hikes in the past.
Two, based on what we learn, what history tells us about stock market performance based on how rate hikes actually went, versus how they were expected to go.
***How good are we at predicting rate hikes?
Not that great.
It turns out investors have underestimated the amount of rate hikes at the beginning of the last four tightening cycles. The miscalculations have been off by between 75 to 175 basis points.
Let’s see what this looks like.
In January 1994, Fed Fund futures priced a gradual rise in U.S. interest rates. Investors were looking for rates to rise from 3% to about 4.25% by March 1995.
The Fed raised rates far more quickly, eventually hiking them to 6% by early 1995 before cutting them back to 5.25%. At the end of the day, the Fed went 175 basis points beyond what Fed Fund futures had expected.
You can see this below.
The dotted, light blue line is what Fed funds futures prices predicted would happen. The solid, dark blue line is what the Fed actually did.
Source: CME Group
Next, in June 1999, the Fed decided it was time to begin raising rates after having cut them in the wake of the Asian Crisis and the Russian debt default.
Fed Funds futures expected the Fed would hike rates to 5% by the end of 1999, possibly 5.25% by mid-2000. The Fed blew past those estimates, raising rates to 6.5%, which was followed by the dot-com recession in 2001.
Below, we again look at the expectation versus reality.
Source: CME Group
In June 2004, Fed Funds futures prices suggested the Fed would raise rates to 4% by mid-2006.
The Fed surprised investors and instead raised the Fed Funds to 5.25%, which was 125 basis points beyond expectations.
Source: CME Group
Most recently, the cycle from 2015 – 2018 threw some curveballs.
Most investors expected the December 2015 rate hike. And going into 2016, investors actually overestimated the Fed’s tightening this time around, expecting two more hikes by November of that year.
Instead, the Fed waited an entire year to hike. But then in 2017 and 2018, it jacked rates to 2.375%, which is roughly 75 basis points further than investors had planned on.
Source: CME Group
Looking at these rate-hike cycles as a whole, investors under-guessed the Fed 100% of the time. And the amount of that under-guess ranged from 75 to 175 basis points.
If history is an accurate predictor, that means the fed funds rate will be closer to 2.75% – 3.75% at the end of the year.
If you think that’s crazy, this morning we learned that St. Louis Fed President James Bullard wants the equivalent of 12 quarter-point rate hikes this year. That would push the fed funds rate over 3%.
Meanwhile, also from this morning, Federal Reserve Governor Christopher Waller said that the Fed may need to enact one or more 50-basis-point rate hikes. That would likely put rates deeply in the 2%+ range, if not at 3%.
So, what does this mean for stocks?
***The important variable to consider
As we’ve noted before in the Digest, stocks actually tend to perform well in rising rate environments. For a while, at least.
When rates get too high, the markets eventually cry “uncle” and sell off. But before that, rising rates tend to reflect a strong economy, which translates into solid earnings, which translates into healthy stock prices.
So, the early quarters of a rising rate cycle are usually bullish.
That said, what can throw water on this bullishness is excessive speed of those rate hikes.
Last month, the research team at Ned Davis Research looked into stock-market performance during a rising rate environment, differentiating between “fast” and “slow” rate hike speeds.
Here’s the quick takeaway, as reported by MarketWatch:
It turns out that when the Fed moves fast to hike rates, as it has signaled it’s prepared to do in a scramble to rein in U.S. inflation running at its hottest since the early 1980s, the stock market’s short-term performance hasn’t been quite as stellar, said Ed Clissold, chief U.S. strategist at Ned Davis Research.
To study this, the researchers went back to the 1940s, looking at rate hiking cycles up to the present day.
In short, what they found is that in a “slow” tightening cycle, stocks did, in fact, climb as historical averages suggest they do. In the first year of a slow rate hike cycle, stocks averaged 10.5% gains.
However, it was a different story for “fast” tightening cycles. In this case, during the first year, stocks lost 2.7%.
Below, we see how this looks.
The left third of the chart shows stock performance in the year prior to the rate hike beginning. The middle third shows what happens in the first year of the hike. The right third shows what happens in the second year of the rate hike.
The “Fast cycle” is the orange bottom line.
Source: Ned Davis Research
Okay, so there’s a big question here:
How fast is “fast”?
Back to MarketWatch:
It’s a bit subjective, Clissold told MarketWatch, but past cycles have shaken out relatively clearly between the two categories.
NDR expects four or more rate increases over the Fed’s seven remaining policy meetings in 2022 alongside the start of a reduction in the size of the central bank’s balance sheet — a pace that would put the cycle clearly in the “fast” category.
Note that the above expectation of four rate increases came from last month. So, if that was considered fast, the current expectation of seven 2022 hikes would be super-fast.
Then, as we pointed out earlier, throw in how recent history shows that consensus estimates usually under-shoot their mark.
All in all, we’re looking at the potential for a blazing-fast hiking schedule. And that suggests some challenges for stocks.
***That said, remember to keep a big-picture perspective
Okay, so perhaps year one of a fast rate hiking cycle is bumpy for stocks.
Well, what happens during year two?
Historically, stocks recoup their year-one losses and then some. Average returns are 4.3%.
Clearly, you’re not going to retire on this, but you’re also better off than where you started at the beginning of the hiking cycle.
So, this is not a bearish “get out of stocks” Digest. Rather, it’s an effort to give you an idea of what’s to come so that you don’t react emotionally.
Yes, stocks typically climb in a rate hiking cycle, but not when hikes come too fast. So, if you see bumpiness this time around, now you know what’s behind it.
But you also know that, historically, stock-market pullbacks from rate-hike campaigns aren’t disastrous, and should be offset by year two gains.
As we stand today, the market has already priced in a great deal of bad news. Whether it’s actually priced in 7+ rate hikes in 2022 is what we’ll find out.
On the other hand, any number of trip-wire issues could result in the Fed changing its mind about hikes, slowing things down. And if that happens, the market could rocket higher as it recalibrates to more (relatively) dovish conditions.
So, how do we sum it all up?
History suggests we eye this new rate hike cycle with caution but not bearishness. And if unexpected good news breaks, which moves us closer to a “slow” rate hike cycle, look for a big rally.
We’ll keep you up to speed here in the Digest.
Have a good evening,