One of the oldest rules on Wall Street is, don’t fight the Fed. When the Federal Reserve is cutting rates, you want to be long equities, and when it is tightening, get out of the way. This has been a cause for concern since the Fed began talking of tapering its program of quantitative easing and ending its zero interest-rate policy.
But the knee-jerk response to an oversimplified rule of thumb might be wrong. When we look at the actual data — what happens to stocks when rates rise — we find a very different set of results than this heuristic suggests. Before I get to the numbers let’s look at both the positive and negative sides of increasing rates.
It is understandable that there is concern with a rising-rate environment. Often, higher rates signal an overheating economy, higher costs of credit to purchase goods and services and a potential profit squeeze as operating expenses rise. When the Fed is in its inflation-fighting mode, too much tightening will cause a recession.
However, there are also positives to increasing interest rates. Rates are merely the price of capital. Higher demand for capital means the economy is strengthening, as consumers borrow to spend on goods and to buy homes and companies seek to hire and do more investment spending. Higher rates also mean the risk of deflation is decreasing. Lastly, it reflects a normalization of Fed interventions, which today would suggest that the credit crisis is behind us.
Each of the positive and negative scenarios has occurred in different economic cycles and they each contain specific combinations of variables. When all of these inputs interact, we end up with a broad range of possible outcomes.
Unfortunately, there is no rule of thumb that will give us a simple investment formula. What the data show is something more nuanced and complex than you might assume.
Consider the impact of rate movements on the Standard & Poor’s 500 Index during the past century or so. On 86 occasions interest rates changed significantly during the course of a calendar year. The effects of these changes produced a diverse array of market outcomes, thanks to the interaction of a variety of factors.