When the Federal Reserve announced a quarter-point interest rate hike and no major surprises earlier this month, it was one more sign of hope for investors that the Fed's aggressive rate-hiking campaign would soon end. Stocks roared higher on the news, and at Tuesday's prices, the S&P 500 (^GSPC 0.02%) was up more than 16% from its October lows.
Does this mean a new bull market is coming? Well, maybe -- there are many definitions, but one thing they have in common is a 20% rebound off bear-market lows. But if you're looking for signs of a turnaround in the economy, there's a better question to ask: What will happen to interest rates this year?
Rates crushed the market in 2022
Rising interest rates were the main culprit behind the market meltdown in 2022. As the economy began to recover from the pandemic shutdowns, high levels of inflation snuck up on the Fed faster than anticipated, and the central bank had to hurry to catch up.
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The Fed raises its benchmark overnight lending rate, the federal funds rate, when the economy is too hot and prices of consumer goods and services are rising too quickly. By raising rates, the Fed makes it costlier to borrow money, which dampens buying power to the point where demand fizzles out and prices eventually fall.
The Fed was so behind on inflation in early 2022 that it has now raised interest rates from practically zero to inside a range of 4.50% to 4.75% in less than a year, the fastest the Fed has ever raised rates in this short of a time period.
But part of the shock is that rates had been abnormally low for more than a decade since the Great Recession, making it easy for companies and consumers to borrow. Rising rates make the cost of debt, and therefore the cost of doing business, more expensive. This effectively reduces a company's future expected earnings and leads the market to lower valuations, which negatively impacts stock prices. And at the beginning of 2022, many stocks were trading at extremely high valuations.
The trajectory of interest rates
Where rates go next has to do with the current state of the economy and inflation. Inflation has shown signs of slowing, with consumer prices rising at a much slower pace in recent months and up less on a year-over-year basis than in 2022.
But one perplexing part of the economy is the labor market, which has remained very strong. The Fed wants the labor market to deteriorate a little bit because it believes that the strong job market and wage growth have been contributing to inflation. However, in January, the U.S. unemployment rate clocked in at 3.4%, the lowest level it's been since 1969, and the U.S. economy added more than half a million jobs, well above economist estimates. Wage growth slowed from December but was still above economists' estimates as well.
There are several scenarios that could play out this year, and they will all impact what the Fed does with the federal funds rate. One is that the Fed's aggressive rate-hiking campaign will tip the economy into a recession. Normally, this would be bad for the market, but investors are also hopeful that this might prompt the Fed to cut interest rates to stimulate the economy, which would make stocks more attractive. So, the idea of a mild recession has been seen as a decent outcome for the market this year.
In another scenario, the Fed succeeds in engineering a soft landing where inflation comes down and unemployment only rises modestly, resulting in what investors refer to as a "goldilocks" scenario. This is also perceived positively, although in this scenario I am unsure if there would be any kind of rate cut because usually, a goldilocks scenario does not result in a recession.
The other scenario is that the Fed's rate hikes come on stronger than anticipated and knock the economy into a much more severe recession, which would hit the consumer hard and create a huge drag on corporate earnings.
It depends on the economy
So the big question to ask is not whether we're starting a bull market but what will happen to interest rates this year. A rate cut, which would likely be triggered by a mild recession, would ironically be the best outcome for stocks and likely trigger a bull market. A goldilocks scenario could also be favorable for the market.
Speaking at the Economic Club of Washington, D.C., on Tuesday, Fed Chair Jerome Powell said that inflation is beginning to ease but that it will be a long process that carries into 2024. He made no mention of potential rate cuts this year.
Unfortunately, I don't think anyone really has the answer as to what will happen to the economy just yet because of the unprecedented situation where the Fed has raised rates aggressively and quickly but the labor market hasn't shown real signs of weakening. Keep monitoring key indicators like inflation and the labor market, because there should be more clarity over the next several months.
