Interest Rates Affect Stocks' Fates

3/2/2015


At some point, probably later this year, short-term interest rates will rise. The federal funds rate, the benchmark for short-term rates, has been kept near zero since December 2008.

Plenty of investors and media members parse the minutes of every Federal Open Market Committee meeting, trying to distill hidden messages and decipher the authors' intentions. Such analysis captures plenty of headlines and can affect expectations.

The Blue Chip Economic Indicators consensus suggests analysts expect the FOMC to raise the fed funds rate this year, possibly by June but more likely around September. Federal funds futures imply at least an 80% chance of a 0.25% rate increase by the end of September, with a 0.50% rise likely by the end of the year. The Fed will revisit the matter at its next meeting on March 17 and 18.

At a glance, it might seem that a gradual and orderly rise in rates should accompany positive stock returns. After all, the decision to boost interest rates would reflect the Fed's confidence in an improving economy.

However, studies show that stocks tend to perform better when rates are falling and worse in periods of rising rates. One such study is featured in the forthcoming book, "Invest with the Fed." According to a review in The Wall Street Journal, the authors analyzed how stocks reacted to the Fed's influence on interest rates from 1966 to 2013.

During expansive periods (when the Fed is lowering rates), the S&P 500 Index generated an average annual return of 12% after inflation. In restrictive periods (rates rising), the index averaged just 0.8%. Stocks averaged an annual return of 6% over the entire 48-year period.

What's behind the tendency for stocks to perform poorly when interest rates rise? At least part of the trend stems from the fact that higher rates can spark conservative investors to move from stocks to back to their preferred securities, bonds.

The key word in the previous paragraph is "tendency," and not all sectors react the same way to interest-rate hikes. In fact, banks and other financials have rallied in recent months when it appeared rates would head higher.

Can we then assume that financial stocks will bounce when the Fed finally announces a rate hike? Not at all. The dichotomy between recent price action and 48 years of history illustrates the importance of selecting high-quality, attractively valued companies, which should outperform their peers regardless of the broad sector's reaction.


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