The Fed and the Stock Market

Tom Beilstein, CFA, Portfolio Manager

Is the Fed Set to Raise Rates?

Rates will almost assuredly go up over the next couple of years. The questions are when and how quickly will they go up. We have been in an unprecedented period of easy money. The Federal funds rate was at 6.50% on January 1, 2001, and after thirteen separate rate reductions, reached 1.00% on June 25, 2003. With the economy heating up and capital spending increasing, it is only a matter of time before inflation fears set in and the Fed steps in by raising rates.

One important item we must consider when trying to determine the timing of the Fed’s first move is the Presidential election. The Fed tries not to influence elections and tends to be inactive in the months leading up to the elections. In fact, since Greenspan took over as the Chairman of the Fed, he has only raised rates one time between Memorial Day and the election. In 1988, he raised rates 0.50% in August. Other than that, rates were left unchanged for the final seven months of the year in each election year except for 1992, when he lowered rates in July and September. So based on these trends, it seems that rates will be left alone until after the election.

Yet, there are a number of indicators that point to a rise in rates before the end of the year. A couple key indicators are already pointing to a pick-up in inflation, which stood at 1.7% as of 3/31/04. The Core PPI Crude Goods Index (excluding Energy and Food) has risen to 26.2%. Core inflation pressures usually show when this index rises over 13%. On the manufacturing side, the ISM Manufacturing Price Index has risen to 86.0%. When this index rises to over 73.5%, corporation inflation pressures exist. In fact, the market is expecting higher inflation. CPI Inflation Futures are at 2.4% and inflation implied by the yield of Treasuries [10-year Treasury Yield (4.4%) minus 10-year Inflation-Indexed Treasury Yield (2.0%)] is also 2.4%. These inflationary pressures coupled with GDP being up 4.23% as of 12/31/03 argue that rates no longer need to be held low and could be raised immediately.

How does the market do after Initial Fed Rate Hikes?

Contrary to popular belief, the stock market tends to do reasonably well following the initial Fed rate hike. There have been 18 times that the Fed has entered a period of tightening policy. The market has actually gone up in the week following the initial tightening 12 of 18 times with a median gain of 0.9%. Six months out, the returns still look reasonable with the S&P 500 gaining 4.7% with 11 positive occurrences. One year out, the market’s median gain is 8.8% with positive results 12 of 18 times. These returns are in-line with the general performance of the S&P 500. So, a Fed tightening does not give us much insight as to the short-term general direction of the market.

With the Fed funds rate at 1.00%, moving up to 1.25% should not be a big deal. The first hike may be seen as a buying opportunity. The concern is if the Fed tries to do too much, too soon. Robert Parry, a San Francisco Fed official, said, “the Fed’s key interest rate has the potential to rise to about 3.50% if inflation averages 1% to 2%.” (Source: Ned Davis Research) The concern is not that the Fed will raise rates immediately to 3.50%, but that investors may look beyond the first hike to a series down the road. That could be trouble for credit-sensitive sectors.

Also surprisingly, financial stocks tend to outperform on a relative basis following an initial Fed rate hike. If there are a number of rate hikes, it is likely that all stocks will produce negative returns. However, historically financials were still the third best performing sector under multiple rate hike scenarios.

Summary

Whether it is in three months or nine months, interest rates are set to go up. History indicates that tightening periods are not the end of the world. The strength of the economy and corporate earnings should enable the market to handle the first part of this storm. Look for the markets to get jittery preceding the initial hike (especially if it occurs at a regular FOMC meeting) and then bounce back once investors realize that the U.S. economy is robust and can withstand rates moving back towards historical norms.

Source: Ned Davis Research.