What's the outlook for the market now that the Fed has raised interest rates?
Find out how historical reactions to previous rate hikes can offer insights into what might happen in 2017.
The Federal Reserve (Fed) raised its benchmark interest for the second time in twelve months today. The latest hike increases the Fed funds rate to a range of 0.50 percent to 0.75 percent following the December 2015 rate hike to a range of 0.25 percent to 0.50 percent. Prior to the December 2015 rate hike, the Fed kept rates between 0.00 percent and 0.25 percent for seven years following the credit crisis and subsequent recession of 2007-2009. Many market participants and investors interpreted this week’s hike as a sign that policymakers believe the U.S. economy has turned a corner towards self-sufficiency. Yet, many may have also expected several more rate hikes to quickly follow the December 2015 hike. This was not the case, as the Fed waited twelve months to take a second step on the path towards more normalized interest rate levels indicative of a truly healthy economy.
Reviewing the 1988, 1994, 1999, and 2004 rate-hike cycles reveals that the Fed followed up its first rate hike with a second rate hike an average of 45 days later. This time, 363 days elapsed between the first and second rate hikes, more than eight times longer than the average time between the first two rate hikes of the previous four cycles. Why have policymakers been so cautious this time? We believe the answer lies in several powerful macroeconomic factors, including inflation and currency trends, which we expand upon below. Despite central bankers’ cautiousness, it seems clear that we are now most likely on a path to higher rates in the U.S. This is an encouraging development for the growing number of American savers. However, we may also be on our way to seeing higher-cost loans for homes, cars and business expansion.
Seven years is an abnormally long time to see rates unchanged. It’s enough time for people to get too comfortable with near-zero cost borrowing and for investors to forget how markets behave when rates start to rise. Our aim here is to look back and provide some historical perspective to address the question: How have markets behaved after a second rate hike? Keep in mind that the number of observations is smaller than you might think.
Looking at previous periods when the Fed increased rates – 1988, 1994, 1999 and 2004 – the big take-away might surprise you. Stock and bond markets performed well in most six and 12-month periods following the first and second rate hikes.
Stocks, as represented by the S&P 500 Index, returned an average of 5.11 percent in the six months following the first rate hike and an average of 4.25 percent in the six months following the second rate hike. In the 12 months following the first hike, the S&P 500 rose an average of 8.72 percent, while in the 12 months following the second hike, it posted an average return of 16.41 percent. This level far surpasses the index’s annual average total over the last 50 years of approximately 9.9 percent. Surprisingly, the bond market, represented by the Barclays Aggregate Index, posted average six-month returns of 1.41 percent and 12-month returns averaging 3.95 percent following the first rate hike. Following the second rate hike, the Barclays Aggregate Index generated an average six month total return of 2.05 percent and annual twelve month return of 6.29 percent. While both 12-month returns are less than the historical rate for the Barclays Aggregate Index, they still represent decent returns relative to current cash yields.
In the December 2015 article, we noted several potentially troubling similarities between 1994 and today’s current economic environment. As seen above, 1994 is the only instance where a rate hike resulted in negative short-term returns for bonds or stock. Thus, any similarity between now and then might give investors pause. While the economy is growing at a similar pace and the stock market is priced at a similar valuation, inflation is markedly lower today than it was in 1994. In fact, the current year-over-year inflation as measured by the Consumer Price Index (CPI) is only 1.6 percent, significantly lower than the 2.5 percent reading that was released before the second rate hike in 1994. Additionally, the average year-over-year inflation across Germany, Japan, the United Kingdom and the United States is approximately 0.6 percent, whereas it was 2.3 percent just before the second rate hike in 1994. Thus, weak inflation in the U.S. and abroad more than anything else seems to be the driving factor behind the Fed’s caution in raising rates too quickly.
In addition to weak inflation trends, other factors have most likely enabled the Fed to delay a second rate hike. These factors have served to tighten monetary conditions over the last 18 months. One important development has been the move higher in 3-month USD LIBOR rates in 2016 against a backdrop of new regulations governing money market funds. These regulations are beyond the scope of this article, but the important point is that short-term inter-bank lending rates have increased significantly in recent quarters. The most important factor has probably been a stronger U.S. dollar which has tightened monetary conditions in the U.S. without any action by the Fed. In the 12 months leading up to the initial hike in 2015 the U.S. dollar, as measured by the U.S. Dollar Index (DXY), appreciated roughly 10.0 percent. In the 12 months leading up to each of the prior four rate hikes the dollar actually depreciated by an average of 3.4 percent. In the most recent 2004 rate-tightening cycle, the dollar fell roughly 15.0 percent from June 2003 to December 2004. This caused year-over-year inflation rates in the U.S. to jump from 1.7percent at the end of March 2004 to 3.3 percent at the end of June 2004. In turn, this created a situation where the Fed was forced to raise rates too quickly in 2004 amid an overheating economy. The current Fed Board of Governors is very likely trying to avoid this scenario.
While ultra-low yields on German and Japanese government bonds should help keep a lid on U.S. 10-year Treasury yields, investors need to account for some risks within their bond portfolios. One of these risks concerns lower coupon levels today compared to previous interest rate hike regimes. The average coupon on the Barclays Aggregate Index in February 1994 was 7.64 percent, but in December 2015 that coupon had fallen to 3.20 percent. While an investor in this index in 1994 would have received coupon income of approximately 7.64 percent in 1994, the price depreciation of the index that year would have more than offset this income – resulting in a total negative return of approximately -2.92 percent during the period between Jan. 1, 1994 and Dec. 31, 1994. In 2016, a total-return investor has much less income than in 1994 to help combat any price depreciation that might occur in their bond portfolio. While expectations are “lower for longer,” fixed income investors may have less protection against an unforeseen rise in rates than they had in previous cycles.
What can we take away from these historical examples as they relate to the current economic environment? Are we destined to repeat the disappointing total returns of 1994 or perhaps worse? This is impossible to predict, but there are some factors to consider. First, the 1994 hike came as a surprise to many market observers. In this cycle, the Fed’s actions and the anticipation of a rate hike has been watched and well-documented for several years. In fact, many commentators argue that a second rate hike is much overdue. Another important point to consider is the volatility of the rate hiking cycle in 1994. That year, the Fed followed up the first 0.25 percent hike in February with five more hikes that totaled 2.5 percent, nearly doubling the Fed funds rate from 3.00 percent to 5.50 percent. While inflation was a front-burner issue in 1994, it hardly registers today, with CPI and wage inflation seemingly well-managed. It is highly unlikely that the Fed would follow the December 2016 hike as quickly and as frequently as the 1994 scenario.
In general, markets historically continue to move in a positive direction after the Fed makes its first move to raise rates. As an eventful 2016 draws to a close, we advise investors to stay focused on the benefits of maintaining an appropriate asset allocation. If you have concerns, we recommend that you reach out to your advisor to review your current financial situation.