Returns in Time of Rate Increases

Investors have been anxious for some time about what rising interest rates will mean for U.S. stocks and bonds. The Federal Reserve kicked that anxiety into a higher gear on Wednesday.

It wasn’t that the Fed raised the fed funds rate a quarter point — everyone knew that was coming. The real news, as my Gadfly colleague Lisa Abramowicz pointed out, was in the Fed’s forecast about what comes next. The Fed now anticipates three interest rate increases in each of the next three years. That’s a big deal given that the Fed has managed to raise rates just two times since the 2008 financial crisis.

The Fed has been eager to raise rates for a long time, but conditions never cooperated. U.S. economic data was wobbly. Markets would go haywire at the slightest suggestion of a rate increase. And economic weakness around the world threatened to spill over to the U.S.

Those obstacles have receded recently. U.S. jobs, wages, household spending and inflation have shown more stable growth in recent months. U.S. stocks appear to have made peace with the prospect of higher rates — the S&P 500 is up bigsince February despite months of saber rattling by the Fed.

That doesn’t mean that the Fed won’t be derailed yet again. A higher fed funds rate most likely means a strong dollar, which hurts U.S. exports. Also, if interest rates around the world remain near zero or negative, U.S. bonds will attract investors and longer-term yields could remain low. No one — not least the Fed — wants to see an inverted yield curve, which effectively puts a ceiling on how high rates can go for now.

Still, the Fed’s plan to raise rates seems on more solid ground, which raises the question of how it might affect stocks and bonds.

To find out, I looked back at periods when the fed funds rate rose by 2 percentage points, which is what the Fed hopes to accomplish over the next three years. (The final month in each period is when the fed funds rate crossed over the 2 percentage point threshold.) Looking at the monthly average fed funds rate since July 1954 — the earliest date for which data is available — I found 22 such episodes lasting anywhere from several months to several years.

I then looked at what happened to long-term government bonds and the S&P 500 during those periods. The data were full of surprises.

For starters, bond investors didn’t do as badly as  might be expected. Long-term government bonds returned a negative 1.3 percent on average over those 22 periods (those are cumulative, total returns). It stands to reason that shorter-maturity bonds held up even better given their lower sensitivity to changes in interest rates.

Individual period returns were all over the map as might be expected, given that interest rates are just one of many factors that influence investment performance. In the best period, long-term government bonds returned 17 percent from December 2003 to May 2005. In the worst, the bonds returned a negative 14 percent from November 1979 to March 1980.

Stock investors fared even better. The S&P 500 returned 6.9 percent on average over the same 22 periods. The highest return was 42.2 percent from November 1954 to September 1956. The lowest return was a negative 24 percent from July 1973 to July 1974.

For stats geeks like me, there’s also this nugget: The returns of both stocks and bonds had a positive skew of 0.3. The positive returns, in other words, were higher than the negative returns were lower.

All of this, of course, assumes a relatively modest fed funds hike of 2 percentage points. No one is contemplating more aggressive tightening at this point, but things can always get out of hand. The average monthly fed funds rate spiked from 4.6 percent in January 1977 to 17.6 percent in April 1980 – a whopping 13 percentage point increase. Suffice it to say, that kind of move requires a whole separate analysis.

For now, it’s far from obvious that the Fed’s plans would inflict any damage to investors’ portfolios of stocks and bonds.

Source: Bloomberg Gadfly,