Section 01 Why the Federal Reserve raises interest rates
The Fed’s principal mandates are to promote maximum employment and stable prices through monetary policy. Adjusting short-term interest rates (via the Fed funds rate) is one of the main tools the Fed uses to accomplish these goals.
When the economy is lagging, the Fed lowers interest rates to make borrowing more appealing and, in turn, induce more economic investment, consumer spending and hiring. When the economy is growing rapidly, typically signaled by rising inflation, the Fed hikes interest rates to make borrowing less appealing, which can slow investment, consumer spending and help moderate prices.
Section 02 How markets have responded when the Federal Reserve raised rates in the past
While every tightening cycle is different, history shows that fears about rising rate cycles can be over-amplified, as higher rates don’t necessarily lead to immediate, prolonged downturns in the stock market or to a recession.
Since 1990, there have been five separate Fed tightening cycles; and except for a mini, single-rate hike “cycle” in March of 1997, all periods saw multiple rate hikes over the course of one to three years. While it is not uncommon to see short-term volatility immediately following an initial rate hike, it’s important to note that the stock market was positive for the duration of each tightening cycle over the past three decades.
Additionally, during the past five cycles, there has been only one instance of a bear market and no instances of a recession occurring within one year of an initial hike. The average length between the initial rate hike and the start of a bear market is 3.5 years, and it’s been 4.1 years between the initial hike and the start of a recession. However, that does not mean there is no risk of volatility.
Take the rate hike in June 1999, for example: Within nine months of the first hike, the stock market saw the start of a bear market, and a recession followed a year after that. However, the four other tightening cycles did not see a bear market or recession occur within at least three years of the initial hike. History can help us draw conclusions, but it does not predict the future.
Will this tightening cycle be like 1999? No one knows for sure. But regardless of whether a bear market occurs after nine months like in 1999 or six years like in June 1994, history has long favored investors who stay the course.
Fed Rate Hikes and Long-Term Performance
Section 03 Asset class returns following a Fed rate hike
While the past is not necessarily a prelude to 2022, the previous five cycles provide insight into asset classes that underperformed or outperformed as rates rose.
In the short term following an initial rate hike, most asset classes underperformed their historical average returns. In the three months following that first hike, only 25 percent outperformed their historical average.
However, investors were rewarded if they held through those initial-hike market jitters, with better than 50 percent of asset classes outperforming their historical average returns over multiple time periods.
While it is not to say that you should always expect better than average returns after a rate hike, it’s important to remember the market will adjust to the new economic reality following a rate hike and asset classes will reprice accordingly. The key to success is having an investment plan in place before a market event such as a rate hike occurs.
Asset Returns Before and After Initial Fed Rate Hikes
Asset Returns After Initial Rate Hike
Section 04 Fears of a 'monster' rate hike from the Fed
Since 1990, there have been 40 separate rate hikes during five Fed tightening cycles. Five of these hikes were greater than the “normal” 25-basis-point rate hike and have often been called “monster” hikes due to their unusual size. The worry with these hikes is often that the Fed is being overly aggressive and will over-correct in its attempt to rein in the economy or inflation and end up doing more harm than good.
The fear of a policy error by the Fed is not a new phenomenon; and while monetary risk is one of many inputs that go into the portfolio construction process, it should not drive investment decisions. Unpredictable policy responses by the Fed happen from time to time, and the most effective way to counteract these concerns is to utilize a forward-looking investment philosophy firmly rooted in diversification and asset allocation. This helps eliminate the guesswork and makes predicting these events largely unnecessary.
And in case you were wondering how the stock market responded to the five “monster” rate hikes mentioned earlier, the S&P 500 was higher one year later in four of them, with an average return greater than 20 percent.
Section 05 What it all means
The old Wall Street adage “buy right, sit tight” rings true as the Fed initiates another tightening cycle in 2022. There’s always uncertainty when monetary policy shifts, but history has shown markets can still perform as rates rise. While every cycle is different, the data show that the initiation of a monetary tightening campaign by the Fed isn’t, by default, a harbinger of bad news.
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