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MARK BLACKWELL — Rising rates and falling markets?

MARK BLACKWELL

MARK BLACKWELL

Two points of prevalent financial wisdom are that (1) after nine years without a rate hike, the Fed will begin a long process of nudging interest rates higher by raising the Fed Funds Rate in September and that (2) rising rates will trigger a decline in stock and bond markets.  Neither is a foregone conclusion.

In two consecutive days in the first week of August, two voting members of the Fed’s policy-setting Federal Open Market Committee issued differing views on the likelihood of an increase in the Fed funds rate. Federal Reserve Governor Jerome Powell noted on Aug. 5 that the conflicting data exemplified by a stronger economy but tame inflation justified a wait-and-see approach to the Sept. 16-17 FOMC meeting.  He stated that no decision has been made on his part and that additional data between now and then could certainly sway him and other members to either raise rates immediately or postpone the increase for future meetings.

The day before Powell’s comments, Atlanta Fed President Dennis Lockhart suggested in a Wall Street Journal interview that he is quite inclined to raise rates already.  James Bullard, President of the St. Lewis Fed, the week before had made the same indication about his own disposition to raise rates.  Both Lockhart and Bullard offered slight hedges to their comments, though, with Lockhart saying that it would take “significant deterioration” in the economic and employment data between the time of his comments and the September meeting for him to vote otherwise.  He also acknowledged, “I don’t think it would be a big policy error to wait somewhat longer,” indicating a willingness to delay the decision to the October or December FOMC meetings.

Weighing each member’s comments, it would seem that a rate increase is likely at the next meeting, but delaying that decision also remains a possibility.

Given the likelihood that rates will begin to rise soon, one might assume that the stock and bond markets will decline.  Ben Carlson, an investment analyst at Van Andel Institute, provides research that indicates long-term declines have not been the market’s response to recent rising rate environments.  Carlson’s study reviewed market performance throughout the last 14 periods of rising interest rates dating back to 1959 and found that stocks moved higher in all but two of them (both in the early ‘70s).  The average return for all periods was a 20.1 percent increase from the time rates began to rise until policy shifted to lower rates.  The average annualized return for these periods was a respectable 10 percent.

Bonds did not fare as well as stocks in rising interest rate markets, but they didn’t suffer the rout that one might expect either.  Bonds were negative half the time, but their total return averaged 2.1 percent throughout the individual periods or about 1 percent on an annual basis.

A couple of factors may mitigate any negative effects of a rate increase in today’s environment.  First, we’ve seen this one coming for a long time!  Rates have been held to near-zero levels for almost seven years and each year a reversal in policy has been anticipated.  The markets have certainly had time to take into account any potential rate increase and price that expectation into security values.  Second, when rates begin to rise, they are likely to rise very slowly.  Fed Governor Powell emphasized this point in his comments on Aug. 5.  That most analysts have expected rate increases for several months and that once they begin to rise they should do so very gradually provide some assurance that the markets will not be terribly disrupted by a measured rate increase.

On the other hand, one signal for greater caution in this environment is that the economy continues to improve very gradually.  Historically, the Fed has raised rates to moderate inflation in a strong economic cycle.

What effects rising rates will have in a persistently weak recovery and in the absence of meaningful inflation may be significantly different than the effects experienced in the periods in Carlson’s studies.

The art of market prognostication is in understanding that no two historical periods involve exactly the same combination of economic and financial influences, so markets may respond very differently to one catalyst today than they did to the same catalyst in the past.  If the combination of art and science tell us anything it is that we should approach the expected rising interest rates with caution, but not with panic.

» Mark Blackwell is a Certified Wealth Strategist® and the Mississippi Area Executive for Regions Private Wealth Management.  He can be reached at mark.blackwell@regions.com. 

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