How Should Stocks And Bonds Perform In 2022 As The Fed Prepares To Raise Rates?

A businessman is consulting a crystal ball to foretell the future.


The Federal Reserve (Fed) has began the exit from extraordinary accommodation by accelerating the reduction in asset purchases by the central bank, which sets the table for rate hikes in 2022. The markets are currently pricing in a good chance that the first policy rate increase will come in March 2022. So how do stocks and bonds typically act in the three months before the first interest rate increase?

Since the Fed only directly controls the short-term interest rates, the impact on the yield for the two-year U.S. Treasury notes should be the most direct as well. Things are never as easy as they seem, though, since the markets adjust to expectations. In our current period of lower interest rates, the two-year yield has consistently risen in the three months before the first hike.

U.S. 2-Year Yield Around The First Federal Reserve Rate Hike In A Cycle

Glenview Trust, Bloomberg

The Fed does not directly control the yield on the ten-year note, but asset purchases and the ultra-low short-term rates certainly have an impact. Again though, in the last four tightening cycles, the ten-year yield has risen in the three months before the first rate increase.

U.S. 10-Year Yield Around The First Federal Reserve Rate Hike In A Cycle

Glenview Trust, Bloomberg

As discussed previously, the yield curve has a phenomenal track record of forecasting a future recession. In most instances, a yield curve inversion was followed by an eventual recession. A yield curve inversion means that the yield on the 10-year U.S. Treasury falls below the 2-year. When the difference between the two yields is falling, it is said that the yield curve is flattening. In almost every recent tightening cycle, the yield curve has flattened in the three months before the first salvo from the Fed.

Yield Curve Around The First Federal Reserve Rate Hike In A Cycle

Glenview Trust, Bloomberg

Stocks historically do not seem bothered at all before the start of a tightening cycle from the Fed. While there is not enough data and other things besides monetary policy impact stocks, it seems like the three months before a hike are not destined to be a poor performer. Stocks appear to get more jittery after the first hike, perhaps with good reason since the last three hiking cycles have ended in recession.

S&P 500 Performance Around The First Federal Reserve Rate Hike In A Cycle

Glenview Trust, Bloomberg

While the crystal ball for 2022 remains cloudy, history would seemingly point to the odds favoring rising short and longer-term yields as well as a flattening yield curve. This data would suggest that bonds are not very attractive relative to other assets, but shorter maturities are likely preferable as they have less interest rate risk. Current inflation levels also make bonds relatively unattractive for anyone with the goal of maintaining purchasing power. Also, it is time to start watching the yield curve closely for signs that the policy actions might send us into a future recession. However, economic activity in the U.S. remains robust, so recession does not currently look near.

Stocks have historically been good performers before the first hike and should continue to benefit from strong corporate earnings and the relative unattractiveness of bonds and cash for maintaining purchasing power. Investors should be mindful that the ride could get a bit more choppy after the first hike if history is any guide. As with every past market decline, this has eventually become an opportunity as stocks rebounded.

Omicron and any other future variants add another level of uncertainty around Fed policy actions. Assuming that Omicron remains highly contagious but does not lead to as many hospitalizations as previous strains of the virus, the Fed should be on track to hike in March. Consumer mobility does not seem to be significantly negatively impacted by the increased infections, but this will need to be monitored. Corporate earnings and stocks prices would likely suffer, while bonds benefitted if the health conditions crimped consumer behavior significantly.