Here's what happens to stocks when the Fed hikes rates

Equities usually react favorably when the central bank tightens, according to new research

Dec 27, 2013 @ 12:35 pm

By Jason Kephart

Now that the stock market is about to sign off on its best year since 2003 and its fourth year of double-digit gains in the past five, investors are starting to look for chinks in the bull market's armor. One place they won't find them, if history is any guide, is in the Federal Reserve Bank's short-term interest rate policy.

The central bank has held the federal funds rate, which is how much banks charge to borrow from each other overnight and what bank deposit and money market yields are based on, at near zero since the financial crisis to encourage borrowing.

Now that the central bank has announced its intention to start tapering its monthly bond buying stimulus package, observers' eyes are slowly shifting toward the fed funds rate as the next shoe that could drop on the bull market.

Last week, the Fed said it will cut its monthly purchase of $85 billion in Treasury bonds and mortgage-backed securities by $10 billion, acknowledging signs that the economy was growing strong enough to start doing without the central bank's hand holding.

In the days leading up to the announcement, there was much concern about what such a move would mean for stocks, but equity markets rallied on the news.

It is likely stocks will do the same when the Fed starts hiking the fed funds rate, which pundits say could happen as early as mid-2015 and as late as after we've all shuffled off this mortal coil, because that's what's happened all but one time the short-term rate has been hiked, according to UBS Securities.

In 1977, for example, the Fed increased its short-term interest rate after two years of more than 20% returns in the S&P 500, but the index didn't top out for another 41 months. The market rose another 41% during that span of more than three years.

Such spikes are consistent four out of the next five times the Fed went from lowering short-term borrowing rates, or leaving them steady, to raising them.

To wit, here is what the S&P 500 returned over post-rate-hike periods, according to the UBS U.S. Equity and Derivatives Strategy 2014 Outlook research report:

• 34.7% over eight months starting in 1986

• 41.9% over 28 months starting in 1988

• 11.3% over nine months starting in 1999

• 37.2% over 40 months starting in 2004

Only in 1994, when the Fed pushed the short-term rate 2.5 percentage points higher to 5.5% over the course of the year did stocks struggle. After the central bank's first rate hike in February, the S&P 500 lost about 1.5% the rest of the year.

It makes sense, since raising the short-term rate, commonly called tightening, is a sign of a strong economy, which is great for corporate earnings.

Bonds, which move inversely to interest rates, will obviously not fare as well during a rising interest rate period, but from a total return standpoint, a balanced portfolio should be able to offset their struggles through the stock gains.

That means the bull market's naysayers are going to have to keep searching for that weak spot.

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