One of questions I’m asked most often is the potential impact of higher interest rates on portfolio returns. Investors seem aware that rates are extremely low—and artificially so, give the Fed’s easy money policy—but that they may return to historic norms.
The catalyst for higher rates could have economic or market-based origins. Stronger economic growth might cause the Federal Reserve to rethink its dovish mindset and put the brakes on asset purchases, which could potentially cause higher short-term rates. Or market participants might start selling Treasury debt for the potential for higher returns in equities. Either scenario could lead to higher rates.
The purpose of this memo is to identify the potential portfolio changes we may initiate if rates appear to be heading higher. Our methodology includes defining raising rate and falling rate periods; measuring the performance of a number of asset classes for each period; and analyzing the results.
High Rates, Low Rates
Perhaps the most straightforward definition of rising and falling rate periods is the concept of a “rate regime”:
A rising (falling) rate regime consists of any period over which the most recent rate action on the Fed Funds target rate was an om (decrease).
Since the Federal Reserve only changes its target rate on a periodic basis and because Fed Funds rate changes tend to occur in series of multiple increases or decreases, these “regimes” can often last months or even years (click on chart below to enlarge).
The next step in the analysis is to determine the performance for various asset classes during rising and falling interest rate regimes. The table below illustrates the results for eight different investments (click on chart below to enlarge).
As the table above shows, the return for stocks during periods of rising rates is similar to periods of falling rates. This is due to many factors, including the increasing latitude many companies have in raising the price of goods sold as rates increase. If rates were to rise, our portfolios would likely be redirected toward growth stocks, which tend to increase more than their value-oriented counterparts during periods of increased economic growth accompanied by rising rates.