An Eye On DC: How Stocks Perform When The Fed Raises Interest Rates

 
One of the biggest risks for stocks in 2013 was the fear that the Federal Reserve would stop quantitative easing and raise interest rates. This was the so-called “taper tantrum” that caused some volatility in late spring, although that bit of history is easily forgotten after the S&P 500 returned over 30% for the full year. It’s also easier to forget after 2014, when rates kept going down just when the market was expecting rates to go up.
Even if Wall Street’s memory is short and the idea of raising rates has receded amidst hotter issues like falling oil prices and a possible tech bubble, it’s still an important issue to keep in mind. The Federal Reserve has made it clear that it plans on raising rates later this year, even if many in the market don’t believe them. We can’t predict the future, but it still makes sense to consider how stocks are impacted by raising interest rates, just in case the Fed goes through with its plans and we see higher Treasury yields later this year.
The Theory
 
The Federal Reserve sets a target for the Federal Funds and adjusts its open market operations to ensure that the rate hits that target. When the rate rises, at least theoretically, we should see interest rates for all U.S. Treasuries rise as a result. When rates for bonds get high enough to attract risk-averse investors, they will pull money out of stocks and into bonds, causing stock prices to fall.
This is the general idea, but like any theory, it’s much simpler and cleaner than messy reality. There are three periods in recent history when the Federal Reserve caused the Federal Funds Rate to rise considerable: in 1988, in 1994, and in 2004. Each interest rate hike was short-lived, the longest being the most recent and lasting about four years. You can find a detailed history of the Federal Funds Rate, both annually and on a more frequent basis, on the Federal Reserve’s website.
 
Bond Impact
 
According to the theory, a rise in interest rates will bring risk-averse money to the bond market. At the same time, rising rates also negatively impacts pre-existing bonds, because the rate of return they offer is lower than the new bonds which are issued at a higher rate. Therefore raising rates are bad for bonds in the short-term, which is partly why low-risk government debt was hit hard in 2013 when the fear of rising rates hit the market hard.
This is especially true for long-term debt, which loses its value the most when rates rise. The iShares Barclays long-term bond fund TLT was one of the hardest hit during 2013:
 
Meanwhile, the supposedly higher risk junk bonds fared much better, even if they were initially hit hard in the taper tantrum. Both the big high yield bond ETFs JNK and HYG ended 2013 flat:
That’s how the market anticipated a raising interest rate to impact bonds, but how did long-term government debt fare during an actual rate hike? If we look at the period 2004-2007, when rates were rising steeply, we see that TLT actually did fine:
In other words, the rise in interest rates was nowhere near as awful as the market anticipated it would be in 2013—and in actual fact, that interest rate hike never even arrived. The market, in all its wisdom, was completely wrong in two ways at the same time.
 
Stock Impact
 
The impact on stocks from rising rates is much more complicated and harder to understand. This is mostly because rising rates are not the only thing that impact stocks and, in markets where other factors are more important, the impact can be minimal. Additionally, the Fed will only raise interest rates in an economy that is seeing positive growth, and that the Fed believes will continue to grow at a healthy rate for some time. Strong economic growth is good for stocks, so even if rising rates are bad for stocks in a direct way, the indirect contributors that make rates go up will be good for stocks.
In other words, the relationship is much less clear-cut than with bonds.
For instance, when interest rates rose in the mid 2000s, stocks were on a massive tear that seemed unstoppable at the time:
Of course, now we know this was the result of an unsustainable housing market. At the time, though, the idea of shorting the market or even seeing a fall in stocks because of the Fed’s movements was considered absurd—even if it was the right call just a few months later.
The same is true for the rate hike of 1994-1995:
And again true for 1988 (I’m using the S&P 500 index here instead of the SPY ETF):
In each case in history, the theory that funds will leave the stock market on rising interest rates had little impact on the bull market for stocks because other factors—namely the strong economic growth that caused companies’ revenues and earnings to rise—were much more important.
This doesn’t mean that we can dismiss fears of an interest rate hike when allocating funds to stocks. In fact, we need to remain keenly aware of the possibility that the Federal Reserve will raise interest rates in a relatively weak economy. This is a particular risk now, as changing demographics and technologies mean the economy is fundamentally different than during the interest rate hikes of recent history. Therefore, a careful consideration of time horizon, risk tolerance, and Federal Reserve expectations need to guide your decisions when it comes to building a portfolio.
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