The biggest economic story of the past two-plus years can be summed up in three words: Inflation. Inflation. Inflation.
And that story might come to a close in the most advantageous of ways for investors: a Santa Claus rally.
2023 was already likely to be a fruitful year for investors. Despite all of its ups and downs, the S&P 500 had been pacing for an above-average annual performance for most of the year. That’s in large part thanks to signs that inflation has continued to slow from its four-decade highs in 2022.
But the past couple of consumer price index (CPI) reports have signaled inflation might finally be in check, bringing about renewed enthusiasm.
Inflation: Foe and Friend?
Inflation doesn’t offer much to like. It erodes the value of your savings, makes the things you buy more expensive, and eats into company’s earnings. In fact, there’s only a few reasons to like inflation; say, if you’re trying to pay off your mortgage early.
But believe it or not, some level of inflation is a good thing. Indeed, that’s why our central bank, the Federal Reserve, has a long-run inflation target of 2%.
When the economy heats up, companies must compete for workers. They do so by raising their compensation offers to potential new hires, and/or by raising pay of existing employees to keep them from defecting to a competitor. To offset these higher labor costs, firms can choose to raise prices, absorb the higher costs, or use some combination of the two. If a company feels confident that consumers will pay up for their goods and services, they opt for price increases, which preserves profitability.
So the Goldilocks situation is for consumer prices to rise because the economy is doing well, but not rise so quickly that, even with their higher pay, people are suddenly priced out of the goods and services they need. “Good” inflation readings, then, communicate social and economic stability.
But what happens when economic growth starts getting too hot, and inflation rises too quickly? Well, that’s when the Federal Reserve steps in.
How Do Interest Rates Affect Inflation?
The Federal Reserve serves many roles in the economy, though primarily, it’s the director of monetary policy. The central bank controls the money supply using interest rate policy (among other tools), and with it, how quickly the economy can expand. Think of interest rates as the cost of renting money. If more people want to rent money using loans, thus increasing demand, the cost of money rises. Interest rates will only rise if the demand for money rises, which is what occurs when economic activity accelerates.
The Federal Reserve sets overnight interest rates used by banks to loan to one another via a benchmark known as the Federal funds rate. This rate is considered the foundation of many interest rates because any changes made to the Fed funds rate typically pass through to business and consumer loans.
One example? The prime lending rate, which is the lowest rate at which non-banks (companies) can borrow money from commercial banks, tracks the Fed funds rate. When loans are quoted to borrowers, they usually offer them based on terms like the prime rate + X basis points. (A basis point is one one-hundredth of a percentage point.) So, let’s say the current prime rate is 8.0%, and the loan terms call for a prime rate + 250 basis points. The interest rate would actually be 10.5%. (8.0% + 2.5% = 10.5%)
The Fed has other tools available to control the money supply, including bank reserve requirements, open market operations, and setting lending standards. But given how directly it impacts people, the Fed funds rate typically gets the most press.
This rate is why Federal Open Market Committee (FOMC) meetings have become so important over the past few years. When the Fed thinks the economy is overheating, it raises the Fed funds rate to reduce the demand for money and cool inflation—and it announces these moves at the conclusion of its FOMC meetings.
However, experts are increasingly optimistic that after more than a year of aggressive rate hikes, the Fed is set on taking its foot off the pedal.
Markets React to the Potential End of Rate Hikes
Prior to COVID, people didn’t worry much about inflation for the better part of a decade. That changed rapidly, however, amid a combination of factors, including:
- COVID stimulus spending meant to keep the economy from crashing
- Disruption in supply chains due to COVID
- A rapid rebound in the job market and economic activity
- A spike in oil and other commodity prices after Russia started a war with Ukraine.
That rocket fuel to consumer prices sent global inflation skyward; U.S. CPI grew by as much as 9.1% year-over-year by June 2022.
The Federal Reserve began responding to this rampant inflation in March 2022, when it raised interest rates for the first time since 2018, to a range of 0.25% to 0.50%. It followed that up with 10 more rate hikes, to its current level of 5.25% to 5.50%.
But the pace of those rate increases has been slowing, and in September, the Fed announced it would press the pause button on rate hikes amid clear signs that the economy was cooling down.
The signs have only become clearer since then. In early November, the Labor Department reported a softer-than-expected October jobs report. About a week later, the October CPI report showed that prices actually remained steady month-over-month, and annual inflation had crept down to just 3.2%.
“A soft landing and permanent Fed pause look increasingly likely, which would lay the groundwork for a strong year end,” David Russell, Global Head of Market Strategy at TradeStation, said in response. “Santa could be coming to town.”
Santa Claus Rally Confirmed?
Russell is, of course, referring to a “Santa Claus rally.” The definition varies depending on who you’re talking to, with some people loosely defining it as any rally that happens in and around Christmas.
But Stock Trader’s Almanac creator Yale Hirsch, who discovered this seasonal pattern in 1972, defined it as the last five trading days of the year, plus the first two trading days of the new year. This year, for instance, if a Santa Claus rally were to take place, it would be measured between Friday, Dec. 22, and Wednesday, Jan. 3. By and large, the Santa Claus rally period has experienced obscenely better-than-average returns.
According to a 2022 note from Adam Turnquist, Chief Technical Strategist for LPL Financial, “The S&P 500 has generated average returns of 1.3% during the Santa Claus Rally period, compared to only a 0.2% average return for all rolling seven-day returns.”
But will we get one this year?
An end to rising interest rates (and perhaps a look ahead toward the potential for future rate cuts) would certainly help. While the Fed pausing rates is a signal that the economy is indeed slowing, lower interest rates are a financial boon for publicly traded companies, who often take out debt to finance their growth strategies. This is especially true in technology and tech-esque stocks—and considering that the information technology sector alone accounts for 30% of the S&P 500’s performance right now, that’s meaningful.
The market has at least one other small wall to climb, and that’s value. At the moment, says LPL Chief Global Strategist Quincy Krosby, the S&P 500 has “reached short-term overbought conditions.” He believes the market will work through these conditions until the market finds its next catalyst, which could be Tuesday’s earnings report from Nvidia (NVDA). Regardless, he’s hopeful heading into the final few weeks of the year.
“Positive seasonality, end of the year window dressing when market leaders find new buyers, and earlier and earlier expectations for a Santa Claus rally could help underpin the rally investors and traders alike are hoping for and expecting,” Krosby says.