Will the bond market meltdown be the undoing of the S&P500?

U.S. yields have surged higher again this week to their highest level since May 2019, after Fed Chair Powell opened the door to a 50bp rate hike at the next FOMC meeting, causing fresh pain for global bond markets.

Uptrend 2

The losses in bond markets are a result of the central banks hiking interest rates to tame surging inflation. There is a mathematical formula in place between bonds and interest rates. When bonds fall, interest rates rise, and vice versa.

Following Fed Chair Powell’s hawkish commentary on Monday, St Louis Fed President Bullard overnight reiterated his preference for the FOMC to move “aggressively” to keep inflation under control and said the FOMC could not wait for geopolitical risks to be resolved.

Bullard also noted he would like to see the Federal Funds rate raised to 3% by the end of this year and compared the current tightening cycle to the tightening cycle of 1994.

As a way of a refresher, between February 1994 and February 1995, the Federal Reserve lifted interest rates from 3.25% to 6%. Initially in 25bp increments but then by 50bp and 75bp steps in response to a strong economy and an inflation rate at……~2.50% vs 7.9% currently!!

What do interest rates/bonds have to do with stocks, I hear you ask.

Interest rates generally rise when an economy is doing well and fall when growth is slowing. It goes without saying when an economy is doing well, the stock market is usually doing well.

However, when interest rates rise too quickly, it can unsettle the stock market. Two recent examples are January 2018 and October 2018, which saw 12% and 20% falls respectively in the S&P500.

Back in 1994, when the Fed started tightening, the stock market fell 10% and then traded sideways for the remainder of the year.

What does it mean for US stocks now?

At this point, interest rate rises are coming from ultra-low levels, and the US stock market appears comfortable with the current market pricing of 7 rate hikes before year-end, taking the Fed Funds to a smidgin over 2%.

However, if the FOMC or the interest rate market comes around to Bullard’s view and decides a more aggressive hiking cycle is required, it can become a problem for equities.

More so, as the Federal Reserve is set to start soon shrinking its balance sheet, global growth is slowing, on top of an energy and commodity shortage, supply disruptions, a war in Europe and deglobalisation and decarbonisation. 

What do the charts say?

The ability of the S&P500 to secure its first daily close above the 200-day moving average at 4464 was a positive development. Providing the S&P500 holds above support at 4400/4380 allow for the rally to extend towards 4580/4600 with scope to 4700.

However, should the S&P500 first lose support at 4400/4380 on a closing basis, it would warn of a retest of support at 4100.

SP500 23rd of March

Source Tradingview. The figures stated areas of March 23rd, 2022. Past performance is not a reliable indicator of future performance. This report does not contain and is not to be taken as containing any financial product advice or financial product recommendation

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