After a very strong rebound for the major market averages over the past week, investors needed an excuse to take profits. They found it yesterday with the $5 pop in crude oil prices to $115 a barrel, as President Biden and allies meet today to discuss new sanctions against Russia. As a result, energy and materials were the only two sectors to finish in positive territory. Yesterday also marked the second birthday for this bull market with the S&P 500 having now doubled from its bottom of 2,237 on March 23, 2020. Our wall of worry looks much different today, as a global pandemic that effectively shut down the economy has led to rapid inflation and tightening monetary policy conditions to fight it. I much prefer the latter.
While I remain optimistic about risk assets through the remainder of this year, based in part on the historical performance of the S&P 500 over the 12-month period following an initial rate hike, we are bound to continue seeing elevated volatility. The track record for the stock market is a little less reliable when considering the next 3-6 months. Still, I much prefer stocks to bonds in a rising rate environment, especially when inflation-adjusted yields are still negative. At the same time, I want to be cognizant of how the economy and markets respond in the months ahead to what could be one of the most aggressive rate-hike cycles in history.
It takes 6-12 months for the Fed's rate hikes to work their way through the economy and slow growth. The onset of tighter monetary policy conditions is in response to robust growth, which means that the economy typically remains strong until multiple rate hikes have an impact on the economy. This is why the stock market tends to perform reasonably well in the year following the initial rate increase.
That said, a more immediate impact can be felt by how long-term rates respond to anticipated Fed actions. The Fed has very little influence over the direction of long-term interest rates with the exception of the bonds it has purchased over the past decade, but that has ended. We have seen as rapid an increase in the 10-year Treasury yield as we have in short-term rates, and the 10-year yield serves as a benchmark for 30-year fixed rate mortgages. This is because mortgage-backed securities must compete with risk-free Treasuries for investor dollars, and the interest-rate spread between the 10-year Treasury and the conventional 30-year mortgage has historically been around 2%. Therefore, the rise in the 10-year yield since the beginning of this year from 1.5% to 2.3% has led to a huge increase in borrowing costs for home buyers.
The average rate on a 30-year fixed rate mortgage hit 4.7% this week, which is up more than 1% from last year, and this increase is starting to weigh heavily on new and existing home sales. The average monthly mortgage payment is at a record high, which is the result of higher home prices and borrowing costs. New home sales declined 2% in February to an annual rate of 772,000, while existing home sales fell 7.2% to an annual rate of 6.02 million. Both figures are lower than a year ago, despite low supply.
This is the first segment of the economy to feel the impact of tighter monetary policy conditions, but it does not have a meaningful impact on the overall rate of economic growth. It does have ripple effects, which could be felt later this year, depending on how high mortgage rates climb. If those ripples become large enough, then they will have market implications that will be relevant to investors, but we are not there yet.
According to DataTrek, the recent increase in the Volatility Index (VIX) to more than 36 has significant historical relevance for the performance of the S&P 500 this year. Since 1990, the index has been higher 96% of the time one year after the VIX closes at 36 or higher. That is also consistent with this historical performance for the market in the year after an initial rate hike by the Fed. Again, stocks should outperform bonds in 2022.
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Lawrence is the publisher of The Portfolio Architect. He has more than 25 years of experience managing portfolios for individual investors. He began his career as a Financial Consultant in 1993 with Merrill Lynch and worked in the same capacity for several other Wall Street firms before realizing his long-term goal of complete independence when he founded Fuller Asset Management. He graduated from the University of North Carolina at Chapel Hill with a B.A. in Political Science in 1992.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Lawrence Fuller is the Managing Director of Fuller Asset Management, a Registered Investment Adviser. This post is for informational purposes only. There are risks involved with investing including loss of principal. Lawrence Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by him or Fuller Asset Management. There is no guarantee that the goals of the strategies discussed by will be met. Information or opinions expressed may change without notice, and should not be considered recommendations to buy or sell any particular security.