The past two years have proven just how unpredictable life is. In 2020, world economies were rocked by Covid-19 lockdowns and travel restrictions. This year, just as economies started to recover, Russia invaded Ukraine causing energy and commodity prices to surge and inflation to rise. Investors must be worried but strangely stocks and shares continue to surge.
For investors who use margin to invest in stocks, price volatility could see the margin requirements rising. Recent interest rate hikes will cause some concern and might constrain some speculation in stocks. Let’s take a look at recent events.
Interest rate increases in the US
On the 16th of March 2022, the Federal Reserve approved the first interest rate hike in three years. The move of 0.25% was a response to fast-rising inflation. The last interest rate hike happened in 2018. During the pandemic the Fed brought the interest rate down to near zero in a bid to stimulate economic activity.
The 25-basis point move has raised interest to between 0.25% and 0.5%. The rate increase is not big enough to put the brakes on the US economy. Still, the Fed has warned that there will be further hikes at each of the following six meetings this year.
Usually, interest rate hikes cause stocks to drop because financing costs increase, reducing both business and domestic investment. People using borrowed funds have less disposable income when interest rates are high, so demand for goods and services tend to drop.
Stock markets rallied
The US stock market rallied following the announcement of the rate hike. The rally in stocks suggests that investors are comforted by the fact that the Federal Reserve is taking action to curb inflation. In tightening monetary policy, the Fed has also shown confidence in the strength of the US economy. Increased stock prices may indicate that investors have already priced in the seven interest rate hikes expected this year.
The expectation is that interest rates will have risen from 0% to 1.9% by the end of the year and to 2.8% by next year. Banks raise interest rates to reduce spending and this helps to curb inflation.
Theory has it that when interest rates rise, bond yields increase and stock prices fall. Still, this isn’t always the case. Interest rate hikes often happen when the economy is strong and markets are bullish. In this environment investors expect a gradual increase in interest rates, viewing it as a prudent move by the bank.
A balancing act
There have been fears that increasing interest rates could trigger a recession. Managing economic growth through interest rate movements is a fine balancing act. If the Fed increases rates too steeply, they run the risk of slowing the economy down to the point of recession. If they move too slowly, inflation may run out of control and this will result in further rate increases. When interest rates are too low the Fed can’t stimulate the economy by dropping them. This brings up the frightening specter of stagflation. Stagflation is a situation where inflation is high and growth lagging, resulting in high unemployment.
Stagflation is rare. Yet, in the 1970s, the US economy faced the situation as a result of rocketing energy prices.
US stock markets are booming
As we head toward the end of March, it appears as if US stock markets have shrugged off the rate hikes showing some of the best performance since November 2020.
On the 25th of March, US Futures on the S&P 500 and Nasdaq posted their second week of gains. At the same time two- and ten-year US treasury notes offered the highest yields in three years.
Yet, economists are warning that the war in the Ukraine and surging commodity prices will impact negatively on stock values this year.
Conclusion
It seems the jury is out on what exactly will happen with the stock market this year. How your portfolio performs will depend as always on a diversified investment strategy.
