Eventual rate hike doesn’t doom investments
Action won’t necessarily lead to market correction
Michael MaehlJune 18th, 2015
For almost a year now, the financial media has been talking about all the real and imagined “what-ifs” that can occur when the Federal Reserve Open Market Committee actually begins to move interest rates higher after over 30 years of the (mostly) opposite behavior.
It appears that the Fed now thinks the recovery has taken hold enough that the record-low levels for interest rates can begin to move up toward more normal levels. As to what’s normal, the guideline I use is to add the rate of nominal GDP growth together with the current inflation rate. In today’s market, that adds up to 4 percent, so we’ve got a long way to go to get to that number.
Markets have been volatile, yet remain trading in relatively narrow ranges. I think one of the main reasons for that is the U word—uncertainty. Traders aren’t sure how to react to the sea change. Proof of that came in a recent study that showed fully two-thirds of all traders have never experienced a full Fed market rate cycle. That combination can lead to lots of market flipping and flopping with no real trend in either direction.
While it’s unclear when the first hike will actually take place, September seems the consensus for now. The Fed has said their decision will be “data dependent” with a special focus on both the unemployment and inflation rates. We have no clue as to what the duration of the rate hike cycle will be or where rates will peak, nor will I be so foolish as to hazard a guess.
For your information, a rate hike cycle is any period in which the Fed has raised its Fed Funds rate in a minimum of three successive meetings, without a cut. Going back to 1976, there have been eight such rate hike cycles with the shortest lasting only nine months; the longest stretched more than three years.
So, before the Fed actually does the deed, let’s take a look back to see how rising rates have affected a few major investment sectors.
My first and most important disclaimer is that no hiking cycle looks exactly the same as any other. Each has its own combination of economic, market, demographic, and political variables. Those prior interest rate hike cycles, however, can offer some insight into what we’re about to deal with. That’s because the main variable in all the markets—investor behavior—hasn’t changed much from past generations, even if the environment around us has changed.
A key to thinking about this is to understand that Fed tightening doesn’t necessarily mean a bear market. The Fed is likely to begin raising rates this fall, but this doesn’t mean markets are in for a major correction. Looking at history, U.S. stocks tend to react negatively initially to the start of a tightening cycle and then rebound six to 12 months later. That said, an initial tightening of our monetary policy is unlikely to end today’s bull market.
Other than some totally unforeseen event, the only causes of bear markets I’ve encountered over my career are either a recession or significant tightening by the Fed. Since what the Fed is suggesting is really only becoming less loose, as opposed to tight, I can’t see any major threat to the overall upward market trend.
Contrary to what you may think, the early cycle of rising rates doesn’t crush stocks. During the 14 cycles in which short-term interest rates rose since 1957, the average annual return has been over 9.5 percent. That’s from when the Fed began tightening monetary policy to when they finished tightening. Not bad at all. Moreover, in the one-year period following the final rate hike of a cycle, the S&P 500 has had a return of more than 14 percent, on average.
During the rate hike cycles themselves, stocks typically do worse than average but still manage to earn positive returns. And while we know that past performance doesn’t guarantee future returns, the S&P 500 has posted a weighted average compound annual growth rate of greater than 8 percent during the eight rising rate periods of the last four decades. And volatility has actually been lower than normal during six of these eight periods.
For some perspective, the 10-year Treasury note return, the basis for most loans, was at 6.7 percent when I started in April 1973. By October 1979, the rate had moved up to 10.3 percent. Inflation was rising fairly quickly, and interest rates rose with it.
In the early 1980s, Paul Volcker, the then-chair of the Federal Reserve Board, was determined to break the proverbial back of that double-digit inflation we had been living in for some time. He did so by cranking the interest rates waaaay high. That action drove the 10-year Treasury note to its all-time high of 15.8 percent in September 1981. You could say that this was the start of the bond bull’s run. It wasn’t until mid-1985 that the 10-year rate was less than 10 percent, but the action worked and inflation dropped.
And then, about 30 years on, in July 2012, that 10-year note made a historic low at 1.4 percent and, as this is written, is at about 2 percent. Quite a swing, to be sure.
When reviewing the Barclays Aggregate Bond Index, we find that bonds have done better than average during the year before and the year after a rate hike cycle begins. The Barclays Aggregate has gained an average of 10 percent (total return) in the 12 months leading up to the first hike of a cycle. It has gained an average of better than 11 percent in the 12 months after the cycle ends. Note that the average 12-month return is just over 7 percent for all periods.
Your real risk exposure in a rising-rate environment has to do with the average length of time your bonds have until they come due. Bonds don’t do particularly well while the hiking cycle is in progress. Rates for investors looking to buy short-term bonds will go higher as interest rates begin their climb. But, at the same time, the market value for fixed-rate bonds generally goes down.
The value of bonds and bond mutual funds with long-term maturities could be hardest hit because investors will be able to buy newly issued bonds offering higher interest rates. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates and is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. You can check the duration of any bond funds you own by looking at its Web page. Our general recommendation is to keep your average maturities at about seven years in this environment.
In today’s market, having an allocation to the international sector makes lots of sense, and it still does when rates are rising. For instance, in the one-year period leading up to a Fed Funds rate hike, the MSCI EAFE Index (European and Asian stocks) has delivered an average return of nearly 25 percent versus the typical 11 percent approximate rolling 12-month period. During the rising rate periods, the EAFE index has posted a weighted average compound annual growth rate of more than 14 percent. Foreign stocks have been negative in just one of the last eight rising rate periods.
I believe that, whenever the Fed actually starts, it will be raising the rates slowly, kind of letting everyone get their investment toes wet before ratcheting them higher. They aren’t going right to 4 percent, in any circumstance.
Further, given the lack of experience with rising rates by most market participants, look for some occasionally heavy selling as the actual beginning of the increases becomes more defined. We may even get a correction out of it. There’s still many who mistakenly believe that the Fed is the only driver of the stock market these past few years. I simply offer this gem from Brian Wesbury in response: “QE didn’t build the iWatch.”
A well-allocated and diversified portfolio will stand you in good stead in this transition time … and, hopefully, in most other market environments, as well.
Michael Maehl is an independent financial adviser and Spokane-based senior vice president of Opus 111 Group LLC, a Seattle-based financial services company. He can be reached at 509.747.3323 or firstname.lastname@example.org.