The chatter is already picking up for the next rate hike.
We’re just three weeks away from another Fed meeting to fix the level of short-term interest rates, also know as the federal funds rate.
But while Wall Street analysts are debating on the size of the next rate increase, there’s a metric that matters even more for the stock market…
It’s called the terminal rate. This is where the fed funds rate is expected to land when the Fed ultimately finishes their hiking campaign.
In other words, it’s not just the journey (or the size of rate increases) that’s impactful to stocks, but the destination (the level of interest rates) as well.
The ultimate level of interest rates can impact stocks in three distinct ways.
How Rates Impact Stocks
The first one – valuations – has already hit investors hard over the past year.
Higher interest rates make future corporate profits worth less in today’s terms. This is reflected in the falling price-to-earnings ratio, which has accounted for nearly the entire decline in the S&P 500 since the peak.
Next, higher interest rates mean investors can earn a decent return on cash without all the risk of investing in stocks. That’s something my colleague Jeff Clark pointed out here this week, and why investors are now getting paid to sit on the sidelines.
The third has to has to do with the outlook for the economy and corporate earnings. Interest rates are a key lever for the Fed to get inflation under control by making it more expensive to borrow and buy things, thus slowing economic activity.
The terminal rate tracks just how high the market expects the Fed to push interest rates. A higher figure means worse implications for the stock market due to the aforementioned variables.
This shifting terminal rate is throwing the stock market around…
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Higher for Longer
Since bottoming in October, the S&P 500 Index went on quite a run, gaining 14% through the start of February.
But since then, stocks hit a wall with the S&P down 5%.
There’s more to the story… specifically with the terminal rate during those rallies and pullbacks.
After peaking in October, the terminal rate fell through the end of January… providing a tailwind for stocks as rate pressures eased.
Take a look at the chart…
Take a look at what’s transpired since the start of February.
The terminal rate is suddenly jumping to new highs following upbeat economic news and stubbornly high inflation. This further fuels bets that the Fed will have to keep rates higher for longer to tame inflation.
Since the terminal rates started picking up again, stocks have been pulling back.
So, there’s much more to the big picture on interest rates than the size of the next hike.
If you want insight into the stock market’s next move, keep a close eye on the terminal rate.
Best regards,
Clint Brewer
Analyst, Market Minute
Reader Mailbag
Will you be keeping an eye on terminal rates to decide your next stock market move?
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