Interest rates and volatility are traditionally old buddies. When, for instance, the Fed cut interest rates in the spring of 2020, the VIX also declined; the same relationship between them persisted throughout 2021. Tumultuous trading on January 24, 2022, largely induced by interest rates, sank the DOW 819 points at its intraday low. On the same day the VIX rose 31%, the largest increase since November 2020.
Interest rates and volatility are not synonymous, but it is like seeing Dorothy and knowing that Toto cannot be far away. The Fed has declared that to curb inflation it will raise Fed fund rates three times this year, beginning in March, by .25% each time. This is disingenuous. A .25% increase in rates to curb inflation or slow the economy is as effective as using a sling shot to stop a charging rhino with a tooth ache. It will have little, if any, effect on the economy or inflation. Nor will three moves of .25%. Even a full point rise in interest rates, we think, would probably not significantly slow inflation. Many investment professionals believe that rates will be raised anywhere from four to seven times this year.
The market and the VIX are not concerned with small, incremental rate hikes. They are anxious and wary over the process of raising rates, the pattern of raising rates, and our inability to know how high they will go. As interest rates increase, the markets should expect a continual spike in the VIX. Volatility frequently creates large swings in the markets, often with a negative bias. The VIX, affectionately referred to as the “Fear Index” or the “Fear Gauge,” is a broad market measure, determined by aggregating the prices of S&P 500 puts and calls and finding their midpoint.
Rising interest rates and an increasing VIX have major implications for investors. Both create uncertainty and risk. The term “volatility” did not originate in the field of finance; it is a word borrowed from chemistry and means a tendency for a substance to vaporize. We are not predicting the markets to vaporize, but we wish investors to anticipate large price movements and to let reason and logic, not emotion, be their guides. They may wish to consider the effects of volatility on the timing of withdrawals of funds for needed income or emergencies. Investors may also wish to compare the past volatility of an equity with their tolerance for risk.
For options traders, the higher the volatility of the underlying stock, the higher the cost for both call and put options. Volatility increases their possible risks and benefits, while rising interest rates generally increase the price of call options and decrease the prices of put options. Investors may wish to consider selling puts and covered calls during a volatile period.
Volatility also creates opportunities for investors. The volatility of a stock and its value are not the same. If investors research a stock and determine its value in terms of cash flow, debt, and future margins, a downward swing in price may present a buying opportunity.
We believe that 2022 will present investors with challenges not seen in 2021. We now have two major elements added to the minestrone that were not present last year. Rising interest rates and volatility will add excitement and bounce and unpredictability to the markets in 2022. We think that staying invested amidst rising interest rates and volatility, while managing risk will be beneficial over time. As always, we wish investors to create fiscal plans, updated by personal changes, and possess the tenacity to abide by them.
