Stock-market investors might not want to take a victory lap even as equities trade near records.
As the delayed impact of the Federal Reserve’s rate-hike policy filters its way through the U.S. economy, a pickup in volatility can be expected.
That is according to Jitesh Kumar, a derivatives strategist at Société Générale, who says the most accurate predictor of long-term volatility in the S&P 500 SPX, +0.96% over the past 50 years or so has been the inflation-adjusted fed-funds rate, or the “real” rate.
And real rates — U.S. Treasury yields minus expectations for coming inflation — have steadily risen since the central bank raised its benchmark overnight lending rate in December of 2015, with the Fed raising rates a total of nine times since its last rate increase at the end of last year.
“The key takeaway from our work over the past few years analyzing the impact of macro factors on equity volatility is that it is the real central bank policy rate that drives the (subsequent) volatility in equities,” said Kumar, in a research note on Friday.
See: Should stock-market investors watch out for a volatility pickup?
Read: Here’s one sign in bonds that the U.S. is poised for a sharp economic slowdown in 2019
Higher interest rates can make stock-market investors nervous because it translates into higher borrowing costs, which can, in turn, crimp corporate investment, earnings and ultimately hamstring economic momentum.
Kumar didn’t clarify if the expected uptick in volatility would lead to lower equity values. But since 1990, periods of higher daily volatility have been more associated with days when stock prices fall rather than when they rise, according to Cumberland Advisors.
In the chart below, changes in the inflation-adjusted fed-funds rate foreshadowed changes in the S&P 500’s SPX, +0.96% realized volatility 2½ years later. In other words, investors have to wait for around 30 months before the real fed-funds rate’s rise starts to lead to turbulence in equities, said Kumar.
Thirty months is usually too far into the future to matter to investors looking for more short-term sources of potential stock-market turbulence.
But equity volatility may start to ramp up from here, given that the central bank had started to steadily increase its key lending rate starting from December 2016, around 30 months from now.
After plumbing as low as negative 3% in 2016, the real fed-funds rate now stands slightly below 1%, back into positive territory.
Yet as the Fed raised rates throughout 2017 and 2018, equities have advanced higher, even if the way up has been paved with sharp corrective pullbacks at the beginning and at the end of 2018.
Since the December selloff, the S&P 500 SPX, +0.96% has climbed more than 17% year-to-date, and is within a hair’s breadth of its April 30 all-time high at 2,945.83.
Other analysts and senior Fed officials have made similar arguments that Wall Street may still contend with resistance, in the wake of the central bank’s push to push rates higher. Capital Economics said the U.S. economy could still face a further slowdown from the spate of rate increases over the past four years.
Fed Chairman Jerome Powell at the Economic Club of New York in Nov. 2018 said, “we also know that the economic effects of our gradual rate increases are uncertain and may take a year or more to be fully realized.”
Check out: Stock-market volatility is being partly fueled by fresh uncertainty about earnings, says SocGen
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