Trading the Slowdown in Interest Rates Hikes
The Federal Reserve is expected to stop hiking interest rates at some point in H1 2023—a development that will impact the underlying markets for stocks, bonds and options
As of February 2023, interest rates are rising, and they’re expected to rise further in 2023.
At present, the federal funds rate—the benchmark short-term interest rate set by the Federal Reserve in the United States—is targeted at 4.50% to 4.75%. Most forecasts suggest the U.S. central bank will raise rates two or three more times this year, bringing the target rate to somewhere between 5.25% and 5.75%.
However, with the Federal Reserve now entering the final stages of its current rate hike cycle, most investors and traders are now planning for what’s next. Based on early returns in the financial markets in 2023, it appears that most investors and traders expect a rebound in both stock and bond valuations in 2023.
So far this year, bond prices are up marginally, as evidenced by the +2% return in the Bloomberg Aggregate Bond Index. The stock market has also outperformed to start 2023, with the Nasdaq Composite, the S&P 500 and Dow Jones Industrial Average all up 14%, 8% and 3%.
Impact on stock prices
When benchmark interest rates rise, the cost of financing becomes incrementally higher for the corporate sector. That’s generally a negative for the stock market, because higher financing costs equate to lower earnings—all else being equal.
After rising in 2021, corporate earnings growth dropped sharply in 2022. Moreover, earnings expectations for the first half of 2023 are flat to negative, as illustrated in the chart below.
The sharp drop in earnings growth from 2021 to 2022 helps explain why the stock market experienced a sharp correction last year. That’s because earnings and future earnings potential play a critical role in corporate valuations.
However, with interest rates expected to increase further in 2023, and earnings expectations still flat to negative for the next couple quarters, how is it possible that the stock market has rallied so much to start the year?
There are two probable reasons for 2023 euphoria in the stock market.
First, the January jobs report was extremely strong. According the Bureau of Labor Statistics, the U.S. economy added over 500,000 jobs in January. Those figures indicate continued strength in the underlying economy, despite the existence of higher rates.
Newfound optimism that the economy could avoid a prolonged contraction are undoubtedly contributing to bullish sentiment in the financial markets.
The other consideration is that the stock market tends to be forward thinking. That means participants in the stock market are looking at earnings expectations roughly six months into the future.
That framework helps explain why the stock market sold off in 2022, as future earnings expectations declined for H2 2022 and H1 2023. But that same forward thinking also helps explain why the stock market has rebounded during early 2023, as expectations for earnings growth in the second half of 2023 have improved.
However, there’s no telling whether the projections for the second half of 2023 will be accurate. If a serious recession does develop in the U.S. during the first half of 2023, the stock market will undoubtedly reverse course at some point in the foreseeable future.
The current battle in the stock market is therefore being fought between those that are optimistic and pessimistic about the economy in the second half of 2023. So far, the bulls are winning.
If the economy continues to produce a healthy amount of new jobs, and the Fed stops raising rates at some point in the first half of 2023, that could fuel further gains in the stock market.
Ongoing inflation reports—like the one on Feb. 14—will play a key role in the Fed’s future decision.
Impact on the bond market
A slowdown in Fed rate hikes during the first half of 2023 could have a huge impact on the bond market.
The bond market suffered extensively in 2022. Bond prices are inversely correlated with interest rates, which means when interest rates are rising, bond prices are generally declining.
That was certainly the case in 2022, as the Bloomberg Aggregate Bond Index had its worst year since the Great Recession.
That said, the outlook for the bond market in 2023 is much rosier. As soon as the Fed stops raising rates, the bond market will be under far less pressure.
Moreover, the end of rate hikes also puts into play the potential for future rate cuts—especially if the economy contracts to a greater degree than expected. Rate cuts are an incremental positive for the bond market because bond prices theoretically increase as interest rates decline.
Looking beyond policies of the Federal Reserve, the bond market could also benefit from higher absolute rates in 2023.
Higher absolute rates on fixed income (aka bonds) usually results in stronger demand from investors and traders. For example, few investors are interested in a bond that pays 1%, as compared to one that pays 4%.
At present, the yield on the 2-year U.S. Treasury bond is 4.50%, which is obviously a lot more desirable than a year ago when it was closer to 1.50%.
When considering the possibility of a forthcoming U.S. economic recession and its potential impact on the stock market, it’s easier to see why a risk-free return of 4.50% might draw more investor interest in 2023, as compared to recent years.
The presence of higher absolute rates could therefore be a driver of stronger demand in the bond market this year, which in the end could also help elevate prices.
That sentiment was echoed recently by Meera Pandit—a global market strategist for JPMorgan Asset Management—who recently told Bloomberg Television, “The attractiveness of bonds going into the rest of 2023 has surged.”
Impact on options prices
There are five important drivers of an option’s value, and one of them is interest rates. That’s why interest rates have their own Greek, referred to as “rho.”
The Greeks are five parameters which include delta, gamma, theta, vega and rho. Each Greek describes a different dimension of risk in an option’s value.
Mathematically, rho represents the amount that an option will gain or lose in value for every 1% move in interest rates.
For example, imagine a given option is worth $2 and has a positive rho of $0.50. If interest rates increase by 1%, that option would theoretically increase in value by $0.50, and be worth $2.50. Alternatively, if interest rates were to drop by 1%, then the option would be worth $1.50.
It’s the same with negative rho options but reversed. For example, an option worth $2 with a negative rho of $0.50 would see its value decline to $1.50 if interest rates increased by 1%. Alternatively, that same option would rise in value to $2.50 if interest rates dropped by 1%.
Rho is positive for long calls and short puts, and rho is negative for short calls and long puts. In other words, an increase in interest rate is generally good news for long calls and short puts, whereas a decrease in rates tends to benefit short calls and long puts.
In general, rho tends to play a bigger role in the value of longer-term options, as opposed to near-term options (much like vega). Rho also tends to be larger for at-the-money (ATM) options, as compared to out-the-money (OTM) options.
However, this does not mean that investors and traders need to adjust their approach to trading options, as highlighted below.
To learn more about trading options in the current market environment, check out this new installment of Market Measures on the tastylive financial network.
To follow everything moving the markets—including the latest commodities news—monitor tastylive, weekdays from 7 a.m. to 4 p.m. CDT.
Sage Anderson is a pseudonym. He’s an experienced trader of equity derivatives and has managed volatility-based portfolios as a former prop trading firm employee. He’s not an employee of Luckbox, tastylive or any affiliated companies. Readers can direct questions about this blog or other trading-related subjects, to firstname.lastname@example.org.