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December 19, 2015

Two Key Points About the Fed’s Rate Hike

Much of the chatter about yesterday’s interest rate hike by the Federal Reserve overlooks two key points. First, over the past 61 years, stocks have tended to rise during the 12-month period following the first rate hike. Secondly, it’s different this time.
Put asterisks by both of those statements.
I’ll start with the reassuring news. As we discussed in the December AAII Dividend Investing report, first rate hikes have been followed by higher stock prices over the following 12 months. Stocks have particularly risen when a rate-tightening cycle was started in response to economic growth. In the six 12-month periods starting in 1954 with core inflation at levels that TIAA-CREF characterized as low, stocks rose four times. Stocks rose every time when core inflation was low, bond valuations were high and interest rates were first raised.
Before you back up the truck, here is the asterisk. Though seemingly bullish for the current environment, the sample size is small. TIAA-CREF’s report, which was the most comprehensive one we saw, only covered 12 first rate hikes. Plus, the current trio of a first rate hike, low inflation and high bond valuations has only previously occurred in 1954, 1958 and 2004. So while the record is favorable, it’s not guaranteed to repeat.
Now onto the second observation: It’s different this time. Since at least 1954 (if not further back), the Federal Reserve has never raised rates from such a low level. The unwinding of the monetary stimulus may well be the subject of economic research and textbooks for years and even decades to come. That's not to mention that large banks are currently being required to meet tougher capital requirements and oil remains in the doldrums, having traded as low as $34.63 per barrel today.
But, it was also “different this time” during periods surrounding other first rate hikes. In 1954, the Korean War had recently ended and the Federal Reserve was just a few years past no longer having to monetize Treasury debt at a fixed rate. In 1972, Bretton Woods had recently ended and the Arab oil embargo ensued not too far afterward. In 1983, Paul Volcker was battling double-digit inflation. In 1998, the tech bubble was quickly enlarging. The point is that there are always events occurring that not only influence the decisions made by the Federal Open Market Committee (FOMC), but also how stocks and bonds perform after the rate hike tightening cycle begins.
What matters going forward is how the U.S. economy performs as well as the magnitude of future rate hikes and the pace at which they occur. The FOMC thought our economy is finally strong enough to withstand a rate hike, though inflation remains below its target.
Globally, economic growth remains weak. China is slowing, while Europe and Japan are stagnant. Commodity-producing countries continue to be adversely affected by weak oil, coal and metal prices. If these conditions continue, it would be easier for the FOMC to justify gradual increases in rates, which Chair Janet Yellen suggested yesterday would be the path going forward.
Rising prices are nice, but the magnitude of the price gains is also important. Periods of monetary tightening have been associated with lower-than-average gains in stocks prices. Small-cap stocks have been adversely affected more than large-cap stocks, but both have realized lower, though—and importantly—still positive, returns. The sample size is small and while history often rhymes, the future has a tendency of unfolding in ways we do not expect it to.
One final note, before you put any weight on a strategist’s or other “expert’s” forecast for what will happen next with interest rates or bond yields, consider how many such predictions about when the Fed would raise rates have been routinely wrong over the past approximately five years. Boasting about being right about calling yesterday’s rate hike is akin to claiming to have correctly forecast rain during a drought: do it enough times and eventually one of the forecasts will be right.
The Week Ahead
The U.S. stock exchanges will close early, at 1:00 p.m. ET, on Thursday. The U.S. financial markets will be closed on Friday in observance of Christmas. Our offices will be closed on Thursday and Friday (December 24 and 25), and there will not be an Investor Update sent next week. On behalf of everyone at AAII, I wish you a merry Christmas.
Dow component Nike (NKE) on will report its quarterly results on Tuesday. Joining Nike will be fellow S&P 500 members Cintas Corp. (CTAS) on Monday and ConAgra (CAG), Micron Technology (MU) and Paychex (PAYX) on Tuesday. These will likely be the last earnings reports from S&P 500 companies released in 2015.
On the economic calendar, November existing home sales and the second revision to third-quarter GDP will be released on Tuesday. Wednesday will feature November durable goods orders, November personal income and spending, November new home sales and the University of Michigan’s final December consumer sentiment survey. Weekly initial jobless claims will be released on Thursday, as usual.
The Treasury Department will auction $13 billion of two-year floating rate notes on Wednesday.
About The Author - Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters. © EconMatters All Rights Reserved | Facebook | Twitter | Free Email | Kindle

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