I recently wrote how the two biggest factors controlling the stock market are earnings and interest rates. I want to focus this article on interest rates because they played a very important role in the extreme market movements we saw over the past five months.

Many people are still wondering why the market dropped so hard in the fourth quarter of 2018. There were many factors involved such as the slowing earnings picture, the US/China trade war, hedge fund redemptions, and of course, interest rates. Looking back, I think the biggest reason was interest rates because the market was clearly telling us it could not handle the series of rate hikes that were coming.

How rate hikes can cripple an economy

In early October 2018, Federal Reserve Chairman Jerome Powell said he would be raising rates three times in the upcoming year. One has to step back and consider how this can really cripple an economy. Higher interest rates affect many areas such as corporate debt, business lending, auto loans, credit card payments, student loans, and of course the housing market via mortgage rates. You might not think it’s a big deal if one of these payments increases by $17 a month, but multiply that by hundreds of millions of people, and you can really see the domino effect. After all, consumer spending is 70% of the economy and higher rates takes away an enormous amount of money that would otherwise flow back into the system.

Let’s look back as to why Chairman Powell wanted to raise rates. The academic reason is that he was trying to fight inflation. In my view, this was a mistake because there was very little inflation out there proven by the fact that the December Consumer Price Index (CPI) actually went negative.

The “not so popular” reason is that the stock market has been rising steadily for years and gave us a cushion for higher rates. Very few people want to talk about this because they actually believe the Fed only looks at economic data and makes rate decisions independent of the stock market. If you believe this, then you don’t belong in this business. Of course, the Fed mostly looks at economic data when the stock market is stable, but if the market starts to tank, they throw all that out the window. Nevertheless, the stock market clearly told us in the fall of 2018 that it could not handle several rate hikes and we were on the verge of a Fed-induced recession.

The role of hedge funds

Another factor that very few people discuss is the amount of deleveraging that was done by hedge funds. Yes, they partially had to sell because of redemptions, but many of them took risk off to adjust for higher rates. For example, a $10 billion hedge fund might actually be working with two to four times that amount because they can borrow cheaply to increase both long and short exposure. Again, multiply that by the thousands of hedge funds that use this same strategy and you have another reason for the decline in late 2018. You can see proof of this in the 13F filings that came out in mid-February 2019. Almost every hedge fund I looked up reduced equity exposure, and many by more than 50%.

‘Patience’ on rate hikes

Now, let’s fast forward to what’s caused the non-stop rally we’ve seen since the beginning of 2019. On January 4, 2019, Fed Chairman Powell said he will be “patient” on rate hikes and reiterated his dovish stance in the late January Fed meeting. Many economists interpreted his statement on January 30th to mean the 3 rates hikes are likely on hold for 2019 and it confirmed the Fed’s pivot to a market-friendly stance. Basically, the teacher is out of the classroom and all the funds that just de-levered turned their machines back on to start the party again. It has been an incredible sequence of funds levering back up combined with very few sellers, as the S&P 500 has not seen a week of distribution since last December. So now when you hear the phrase “Don’t fight the Fed,” it should hopefully make sense to you.

Many people complain that the stock market is in a Fed induced bubble and want the Fed to raise rates aggressively. My first response is a growing economy with low inflation is a good thing. Why mess with it and start a recession for no reason? My second response is you have to adapt to what the market gives you. Traditionally, “normal” interest rates have been around 4-5%. One has to consider that we might be in this “new normal” environment of lower rates for a long time. Do I think rates should be higher? Probably because, in theory, when government borrowing increases long-term treasury yields are supposed to go higher. It just hasn’t happened but it’s not the Fed’s fault because they only control short-term rates. Longer rates have stayed low because they are still much higher than long-term rates globally, so that entices foreign investors into buying U.S. bonds and that pushes yields down. There are other powerful forces involved but stop trying to be an economist and simply adjust to the market. Instead of complaining, take advantage of this interest rate friendly market environment while it lasts.

What happens from here? For now, the Fed is no longer an enemy of the stock market. If we see a series of heated monthly jobs reports combined with a stock market that is approaching new highs, we are likely to see the Fed resume interest rate hikes. My guess is they will only discuss one hike at a time and give the economy time to absorb it, rather than scare the markets by hinting at many hikes. Either way, the past five months should be a great reminder as to the importance of interest rates. They can have a domino effect on the entire economy, and changes to rates can add higher than normal volatility to the stock market. It’s definitely something to pay attention to going forward.

Read more:

The first sign to look for to tell if the market or a stock is healthy

Why FAANG stocks might be dead money for a while

The market moves because of 2 main factors

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