As expected, yesterday the Fed raised its benchmark fed funds target interest rate by 25 basis points. Markets reacted very positively to the news as the Dow advanced by 112 points and the S&P 500 gained nearly 20 points. The advance was seen as affirmation that the Fed believed the economy is doing well and could not only withstand higher interest rates, but that higher rates are warranted.
This rate hike may have been the worst kept secret in recent memory. The CME Group's Fed Watch Tool, based on fed fund futures prices, had pegged the probability of a rate increase at near 90 percent. That indicator has the likelihood of a rate hike following the early May Open Market Committee meeting at a minuscule 6 percent, while a rate hike in June is essentially a 50-50 proposition. Most pundits are forecasting two additional rate hikes in 2017.
After years of unprecedented easy monetary policy and historically low interest rates, monetary tightening and higher rates are on the horizon. While predicting the direction of the stock market is a fool's game, as philosopher George Santayana said "those who cannot remember the past are condemned to repeat it." What can history tell us about rising rates and market returns?
While some contend that rising rates are good for stocks, as it indicates that the Fed has more confidence in economic growth, the historical evidence suggests otherwise. In an article published in the Journal of Financial Services Professionals entitled “The Association Between Federal Reserve Policy and Sector Returns,” Gerald Jensen of Creighton University, Luis Garcia-Feijoo of Florida Atlantic University and I found that over the time period from 1966 through 2014, stocks returned 15.2% when rates were falling and only 5.7% when rates were rising.
When referring to monetary policy and its influence on markets, financial analyst and market commentator Martin Zweig said "money makes the mare go." As the Fed pulls away the proverbial money punchbowl, equity investors are wise to lower their return expectations.
Now, there are some sectors that thrived during a rising rate environment. The sectors that performed best when rates were rising were energy (11.2%), consumer goods (8.1%), utilities (7.9%), food (6.7%), and financials (6.5%). Investors may want to boost their holdings in these sectors as the Fed raises rates.
The impact of rate hikes in the bond market is much more straightforward. Simply put, as rates rise, the value of existing bonds fall. And, the value of longer term bonds will fall more than the value of shorter term bonds.