In December 2016, the Federal Reserve raised its Fed funds target interest rate for only the second time in over 10 years, the first time being in December 2015.
Now a possible Fed rate hike next week (March 14/15) is currently priced in by traders as extremely likely (88%), via the CME Group FedWatch tool. This is a big perception change from just two weeks ago, when it was less than 25% on an increase.
And the Fed plans more rate hikes later in 2017, 2018 and likely into 2019, two to four total increases each year.
Should you be concerned that interest rates look to have bottomed after a long stagnant period at historically low levels?
First, let’s put into perspective just how low rates have been and how long they have stayed low.
Take a look at the chart below, which is from the St. Louis Fed:
Effective Federal Funds Rate Chart
You can see that rates haven’t maintained such a low level, for such a long period, at any time in the past 60 years. So, the bottom line on an absolute basis is that the Fed Funds rate is extremely low compared to normal levels, and small bumps higher in it are somewhat insignificant on an absolute basis.
What are some historical parallels for the current anticipated rate hike cycle, and how did they affect the stock market?
Well, over the past 20 years, there have only been three generally recognized Fed rate hike cycles — in 1997, 1999 to 2000 and 2004 to 2006.
The 2004 to 2006 cycle is the most similar to the current anticipated setup, as it lasted two years. It went from a beginning Fed funds rate of 1% to a peak rate of 5.25%.
The current cycle that began in December 2015 may be different than that, as it will likely last longer than two years, and it is not projected to take rates nearly as high. Expectations are that the Fed will look to raise rates to around 3%, and even that may be a bit optimistic on the high side, unless economic growth and inflation picks up.
How did the market do from June 2004 to August 2006, from when the Fed began raising rates until when it completed? Well, the S&P 500 Index (SPY) gained around 16.5% over that 26-month time frame. Annualized, that is around a 7.6% return. Not an incredibly strong gain, but not a bear market in the least.
Of course, it must be pointed out that there was a major market top a year later, in 2007. This was followed by a historic plunge in the S&P 500 of around 42%, until it reached the infamous “666” bottom in early 2009.
In general, an environment of slowly rising rates is often said to benefit sectors such as Financials.
Let’s see if this held true in the 2004 to 2006 rate hike cycle. In that time frame, the SPDR Financial Sector ETF (XLF) gained about 17.5% — in line with the broad stock market, but not a strong outperformance.
There also is a general school of thought that dividend stocks may underperform in a rising interest rate environment. This would be because shares that are bought primarily for a high dividend yield would be less attractive as bond interest rates climb.
There were only a couple of well-known Dividend ETFs that were around back in 2004, iShares Select Dividend ETF (DVY) and First Trust Dividend Index Fund (FVD). It must be pointed out that both of these ETFs tend to hold “blue-chip” type dividend names, not the more speculative stocks with abnormally high (and potentially risky) dividend payouts.
Nonetheless, DVY and FVD both gained around 20% in the time period examined. So, they actually minorly outperformed the broad market.
Fed Rate Hike and Other Scenarios
All of this discussion above assumes that interest rates will climb in a slow, steady pattern, due to continued economic growth and rises in inflation. That could be derailed by a weakening economy or a recession. That is one reason the Fed has begun raising rates from abnormally low levels — so that it has some ammo available to cut rates in the future if needed.
Finally: If interest rates somehow began to rocket sharply higher, as they did in the late 1970s/early 1980s, then all bets are off. The world (national banks, large multinational corporations, etc.) has become so accustomed to dirt-cheap interest rates that a big upwards spike would likely cause massive and unpredictable global economic problems.
Before you worry too much about the Fed rate hike as a precursor to that sort of scenario, it doesn’t seem likely to occur any time soon.