Despite Eerie Calm, Stocks Are Where They Should Be in the Rate Cycle

  • S&P 500 volatility in line with historical trends, BofA says
  • Equities remain tranquil heading into FOMC meeting this week

Market Must Catch Up on Fed Dot Plot, Says Carl Weinberg

The alarm bells over potential bouts of stock volatility surrounding the Federal Reserve’s anticipated interest rate hike this week may be misplaced.

The current tranquility in U.S. equities is unprecedented by some measures, but it’s in line with Fed tightenings since the early 1990s, where the S&P 500 Index has shown growing stability about half way into a cycle, according to a research report on March 8 from Bank of America Corp. rates strategists led by Carol Zhang and Vadim Iaralov.

The monetary environment looks good for stocks, the strategists wrote, as the central bank is all but guaranteed to raise rates Wednesday, following an increase in December, and with more hikes likely to come this year.

“Based on where we’re historically, the risk is falling,’’ Iaralov said by phone. “Part of it is the aligning of expectations. It’s like you get on a train and you’re half way to your destination, it’s easier to expect what’s going to happen. When you arrive or are trying to catch a train, things can be a little different.’’

That’s how it has occurred this time. After posting three weeks of at least a 1.5 percent drop in the first seven weeks following the initial rate hike in December 2015, the S&P 500 has since posted only three declines of that size. In total, the number of weekly pullbacks was less than all others at this point in a hiking cycle.

‘Continue To Rumble’

“Because the correlation between the stock market and bond yields is unusually positive today, even though the Fed is finally starting to increase interest rates, rather than stumble soon, the stock market may just continue to rumble,” Jim Paulsen, chief investment officer at Wells Fargo Capital Management, wrote in a note Monday.

Not everyone agrees that the equity market can remain calm following another rate hike. Last week, UBS Group AG strategist Julian Emanuel cited the Fed as one likely catalyst for a selloff that may send the S&P 500 to as low as 2,192. MKM Holdings derivatives strategist Jim Strugger urged investors to use options to hedge against potential losses in stocks.

“It would be a mistake to pooh-pooh the impact of Fed tightening surprising markets with its pace and magnitude,” Strugger wrote in a note last week.

Options traders are gearing up for rising volatility ahead of the meeting of Fed policy makers tomorrow and Wednesday. The Credit Suisse Fear Barometer, which measures the relative cost of S&P 500 bearish options over bullish ones three months from now, jumped 36 percent last week, the most since 1997.

The stock market has shown little signs of budging even as the options-implied probability of a Wednesday Fed hike increased to a virtual certainty from about 50 percent at the end of February. The S&P 500 has gone without a 1 percent decline for 104 days, the longest stretch since 1995, data compiled by Bloomberg show.

“The equity market has grown more comfortable over time,” the Bank of America strategists wrote.

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