18 Dec 2015 What Do Rising Rates Mean For Stock and Bond Investors?

First let’s celebrate the fact that Janet Yellen actually did what she said she was going to do – she raised rates before the year was out. Investors love certainty and the Fed Chair just improved her certainty rating substantially – how refreshing.

Second, there’s no guarantee that just because the Fed has begun its policy of raising rates, that rates will indeed rise substantially, anytime soon. As powerful as the Fed is, the market is more so, a lot more so. While the Fed carries a lot of weight, both directly through the buying and selling of billions of dollars’ worth of bonds, and indirectly through its announcements, observations and predictions about the economy, the global markets can indeed move counter to their policy. In fact, as the Fed’s overnight target rate for lending between banks hit 0.35% on Thursday, yields on Treasurys, from one-month T-bills to 10-year notes, fell as demand from investors drove prices higher. So while keeping their word on policy changes is important, it is more important that they actually bring markets along.

Generally, when the Fed increases rates or the cost of money they lend to banks, they are suggesting the economy is growing and easy or cheap money is no longer needed to bolster a formerly struggling economy. In this case, our economy has been on a ‘free money’ regimen for seven full years since the financial crisis.

The relatively slow recovery of the US economy has generated few signs of the adverse effects of cheap money (inflation, price bubbles on stocks or commodities). Fed officials now believe it is sufficiently healthy to stand on its own without the near-free money available for the past few years. But the unprecedented volume of money (from Quantitative Easing 1, 2, and 3) that must be sopped up is unprecedented. No one knows how this tightening will unfold relative to others before it, especially in a world that is not as healthy as the US economy.

Nevertheless, a look back can provide some understanding of what to expect. Heather Kennedy Minor of Goldman Sacs provided some good historical insight in a late August article:

In the last 32 policy-rate hike cycles globally, local equity markets gained a median 12% in the 12 months leading up to the start of the new rate cycle. A similar pattern emerges from the same sample of global cycles after the onset of a new rate regime, with the median equity market rising 10% in the year following the initial hike.

The trend over one and two-year periods in the U.S. recently has been similar. The S&P 500 Index (Index) gained an average 17% during the 12-month periods leading to the prior three rising-rate regimes beginning in 1994, 1999 and 2004. Then, after the Fed raised rates, the Index in the above cases added another 6%, on average, in the subsequent year

While the prospect of rising rates after a period of extraordinary monetary policy may give some investors pause, the generally held theory behind rising rates’ and rising stocks’ coexistence is quite simple: benign economic environments. If the broader economy is expanding, this thinking goes, higher rates may simply reflect the rising pace of economic activity. Economic expansion has historically been an underpinning of corporate earnings growth, which historically has often been identified as a driver of long-term stock returns.

There’s also great concern about bonds when rates rise. We use an index of 7-10 year Treasuries, primarily to reduce the risk of volatility in portfolios caused by common stocks. Treasuries trump corporate and municipal bonds when crises cause extreme uncertainty because they have the strongest backing on the planet. But they still succumb, at least temporarily, to the pressures of rising rates.

That said, those temporary losses can disappear in an instant when a crisis arises or losses can disappear over time as newer, higher-yielding bonds are added to the portfolio. This process of replacement occurs in the fund we use to track the 7 to 10 year US Treasury Index keeping it’s rates current and prices relatively insulated from price drops. Because of the unique characteristics of Treasurys and the replacement of higher yielding bonds, the index has never suffered a loss greater than 9% in any 12 month period and it has never suffered back to back annual losses.

A major segment of the economy, the housing industry, will likely be immediately impacted by rising rates (or the promise/threat anyway). One would expect a surge in refinancings and pressure in the home purchase pipeline to accelerate in the face of perceived rate increases.

There is also immediate impact on anyone borrowing money at adjustable rates; from individual credit card borrowers all the way up to major businesses. As rates rise, no matter how small at first, borrowing and spending begin to slow at the margins, weighing on economic growth ever so slightly at first.

But, as we’ve said before it’s a bit different this time in that banks have not been active in lending money to businesses with any kind of risk. Instead they have borrowed money from the Fed at near zero and purchased Treasuries only to pocket 1-2% profits risk-free. By increasing the price of money lent to banks, the Fed forces them to do what they were chartered to do: lend money. As a result, businesses without alternative funding sources will soon be able to start new ventures, create new services and products, and employ more people.

While banks raise their borrowing rates immediately upon hearing of Fed rate hikes, they are a ‘tad’ more plodding when it comes to raising rates for their depositors. Expect money markets to be huge beneficiaries of deposits when their ads begin touting higher rates.

In short, we have a Federal Reserve and a market that seem to be in agreement over the need for higher rates in the US, but only slightly higher. The Fed does not want to overplay its hand. A substantial number of world and domestic economic leaders think it’s too early for higher rates. If the Fed moves too far or too fast, and the market moves counter, its credibility could be damaged enough that they might become less effective during the next crisis.

A combination of factors indicate that their rate increases will be measured both in incremental size and in absolute range. The US economy is not screaming by any means and inflation threats seem distant at best. So there is no great hurry to soak up excess reserves. The global economy is weak, and in many key areas like China, South America and, to a lesser extent, Europe are getting weaker.

It’s fair to say that as long as the Fed continues raising rates, we can take comfort knowing that a lot of smart people with access to far more information and tools to study it than most anyone on the globe, believe that our economy is better off with higher rates than lower ones. Rising rates, under the leadership of this Federal Reserve so far, looks to be a good thing for stock and bond investors.