Fed tightening should not disrupt stock market

After an initial pullback, history suggests equities will withstand interest rate hike

Aug 29, 2014 @ 10:44 am

By Jeff Benjamin and Trevor Hunnicutt

As the Fed moves closer to the start of its first interest-rate tightening cycle in a decade, financial professionals are generally hoping for the best as they brace for a dive into an unprecedented market environment.

“The stock market is illogical, and driven by human emotion, and I do not know how the animal spirits will interpret an interest-rate rise,” said Rick Kahler, president of Kahler Financial Group Inc.

“Conventional wisdom says that the market will go down [when rates go up], but I'm not convinced enough of that to risk my capital and my clients' capital,” he added.

Conventional wisdom, along with historical data, are on the side of relatively smooth transition into a Fed tightening cycle. For starters, raising short-term interest rates means the Federal Open Market Committee believes the economy is strong enough to absorb an increase in borrowing costs, which should be interpreted as positive economic news.

Bolstering that view this week was an upward revision in gross domestic product growth in the second quarter from 4.0% to 4.2%, preceded two days earlier by another milestone for the stock market, when the S&P 500 Index closed above 2,000 for the first time. For the year, the broad index is up around 8%.

But the U.S. economy is still in unprecedented territory as it winds down six years of record-level quantitative easing, leaving the Federal Reserve with a $5 trillion balance sheet of Treasury and mortgage bonds.

(Related: Federal Reserve chairman Janet Yellen stays loose on monetary policy)

Based on the unemployment and inflation targets set by the Fed, the economy is already healthy enough to handle a nominal move off the current floor of near-zero short-term interest rates. But there is still wide speculation as to when and how the Fed will start to take action.

“If we keep getting positive economic reports, I believe [Fed Chair Janet] Yellen is going to have to move up her time table for raising rates, or else the Fed will be significantly behind the curve,” said Doug Cote, chief investment strategist at Voya Financial Inc.

The current consensus among market watchers is that Ms. Yellen will likely start raising rates at some point during the second half of next year, and Mr. Cote believes the equity markets are currently prepared for that time period.

“A rate hike in June of 2015 is already factored in because the markets tend to adjust to the consensus,” he said. “But I believe it will happen in March or earlier, and the market has not adjusted to that yet.”

In terms of market adjustments, or volatility, in the wake of rate hikes, history shows that staying put has been the most prudent strategy.

“Having had such an accommodative Fed for such a long time, taking away the punch bowl might be the catalyst to pull this market down,” said Jason Nicastro, market and investment strategist at LPL Financial.

Considering how well the equity bull market has been shrugging off rising global terror and other geopolitical risks, Mr. Nicastro said he views a rate hike as the next likely risk factor facing stocks.

(More: Are you prepared for the next bear market?)

In his analysis of interest rate hikes over the past 50 years, Mr. Nicastro found that initial market drops are to be expected, but investors who do not panic are usually rewarded.

His study of 25 initial rate hikes over the past 50 years found that the average performance of the S&P 500 during the first month was a decline 78 basis points. And the average returns for periods ranging from three months to 12 months were gains of between 2 basis points and 5.8%.

More significantly, the S&P's average gain from the initial rate hike to the next peak over that 50-year period was 58%, ranging from a low of 12% to a high of 229% during the late-1990s tech bubble.

Paul Casazza, a partner at Dashboard Wealth Advisors, said he has been preparing for higher interest rates because he believes the U.S. economy is ready for it.

“We took a little bit from U.S. equities as part of our rebalancing” he said. “We didn't shift stock-to-bond ratios, but we moved those equity gains to developed international, mainly Europe, which we think is really cheap.”

Judging purely by the Fed funds futures market, the anticipation is for the Fed to start raising rates in about 12 months, according to Robert Keiser, vice president of global markets intelligence research at S&P Capital IQ.

“Janet Yellen has done nothing to suggest she will raise rates any sooner or later than a year from now,” he said. “And that's so far out in the future that shorter-term considerations like Ukraine and a weaker European economy are still dictating bond prices.”

In other words, it is still too early to worry about higher interest rates.

“There is a minority camp that thinks the Fed should raise rates sooner,” Mr. Keiser added. “The bond market seems very comfortable with what the Fed is doing at the moment, but that validation can dissipate very quickly.”

Along those lines, the Fed is getting points for transparency by trying to avoid surprising the financial markets.

“I don't really think the equity markets are that vulnerable to higher rates because we've been talking about higher rates for years,” said Jeff Kravetz, regional investment director at U.S. Bank Wealth Management.

“I think investors are very prepared for the Fed to raise rates when it's appropriate and the time is right,” he added. “Raising rates is a very positive sign for the economy, even though there will be some noise in the markets the first time they do it.”


How do you think the market will react when rates rise?

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