Two financial trends have dominated markets so far this year: higher interest rates and lower equity prices. But at what point do these two trends come into conflict?
When it comes to higher rates, the Federal Reserve (Fed) has already raised rates 1.5%, and both Fed fund futures and the Fed’s own statements suggest that they might hike another 0.75% in July and possibly another 0.5% or 0.75% more in September.
Meanwhile, the S&P 500 is 24% off its recent highs. The Russell and the NASDAQ have fallen by a third. Normally when equities fall, expected interest rates decline but that hasn’t happened amid persistent inflation.
What’s more is that equities might still be overvalued. As we pointed out in a recent paper, the net present value of expected future dividends suggests that the S&P 500 might need to correct another 1,000 points before it comes in line with fair value.
If equity prices continue to fall, it presents central banks with a dilemma: either keep hiking rates to fight inflation and risk further upsetting equity markets, or stop hiking rates to support financial markets at the risk of failing to contain inflation. If falling equity prices do force the Fed to delay or halt rate increases, there is one asset that might benefit more than any other, and that’s gold. Gold prices have been moving sideways for two years but any halt to Fed rate hikes might provide the impetus for a renewed gold rally.
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