The US Federal Reserve is trying to unwind a mammoth $8.9 trillion balance sheet and raising interest rates by half a percent each month. Their goal is to reduce inflation from its forty-year high without driving the country into a recession. They want to achieve the ideal “soft landing” instead of a “hard landing.” How hard will the landing be. To put things in perspective this is an impending disaster largely of their own making as they along with two presidents and Congress flooded too much money into the economy and now the American people are paying the price. Unfortunately, there are complicating factors namely the persistence of Covid in China where the government insists on locking down tens of millions of people and gumming up the supply chain. And, of course, a crazy Russian dictator has taken over a fifth of the neighboring country of Ukraine, blocked grain exports through the Black Sea and is likely to cause widespread hunger, social, and political unrest throughout Africa, the Middle East, and South Asia. Achieving a “Goldilocks” outcome is going to be virtually impossible.
What Happens When Interest Rates Go Up?
The overall effect of raising interest rates is that the economy slows down. Borrowing gets more expensive. Many goods and services go up in price. When the pain is bad enough businesses quit investing, consumers quit buying. Business slows and companies quit hiring or even lay off workers. Fewer workers mean less spending and the economy slows. Prices quit going up or even fall. When raising interest rates is overly aggressive the economy shrinks and the country goes into a recession with higher unemployment. Paul Volcker’s now-famous raising of rates that killed the stagflation of the 1970s caused a recession and drove up unemployment for the following seven years.
Effect of Higher Interest Rates on the Stock Market
When rates go up and drive the economy down stock prices fall due to lower earnings. This is what we are seeing in the market now as the S&P 500 fell 18% from the start of the year until it staged a brief recovery by early June where it is now ONLY down 14%. Prices (inflation) is still up and the economy is adding jobs so the Fed is likely to keep raising rates. As we noted a month ago a stock market crash can last a long time when there are complicating factors. The example we used in that article was the 1929 crash which really lasted until mid-1932 and sucked 90% of the dollar value out of the Dow Jones Industrial Average.
Complicating Factors and Hard Landings
In the case of the 1929 crash the stock market was propped up by borrowing. In that era, one could buy stocks by putting down 10% and borrowing the rest from the broker. It should not be a surprise that only 10% of market value remained when the market finally quit falling. However, the situation was complicated by an ill-advised trade war with Europe. The Smoot-Hawley Tariff Act caused a trade war that turned a stock market crash into the Great Depression. Today we have had an overpriced stock market largely caused by the fact that interest rates were very low ever since the Financial Crisis. That fact is comparable to how investors borrowed to invest in stocks in the 1920s. The situation today with war in Ukraine, lockdowns in China, and rising protectionism are today’s version of the tariff that turned a market crash into a decade-long depression. A hard landing is probably much more likely than a soft landing for the economy and the market no matter how hard the Fed tries to remedy the situation. All things considered, you are better off trading options today than investing as options traders can potentially make money no matter which way the market is heading. Sign up with one of the squadrons at Top Gun Options and get ready to print money even as rates go up and stocks go down.