Don’t Panic Over Eventual Rate Hikes

by Dan Burrows | March 19, 2013 10:10 am

No one expects any policy changes out of the Federal Reserve when its rate-setting committee wraps up a regularly scheduled two-day meeting on Wednesday, but that won’t stop the nervous chatter over when the central bank will finally take away the punch bowl and let interest rates rise.

Core inflation remains in check and we’re no where near the 6.5% unemployment rate Chairman Ben Bernanke says the Fed needs to see before raising short-term rates. Heck, the central bank doesn’t forecast unemployment dropping to that trigger level until 2015.

So short-term rates will stay put at essentially zero, and quantitative easing — that program where the Fed buys $85 billion in long-term debt every month — will keep running for the foreseeable future.

But neither policy will last forever, and given how much credit those ultra-low rates get for boosting prices of everything from stocks to bonds to commodities, it’s no wonder Wall Street is terrified at the prospect of the end of nearly free money.

Indeed, rates have been so low for so long — at both the short and long ends of the yield curve — we’ve almost forgotten what “normal” interest rates look like.

Short-term rates, which the Fed controls through the Federal funds rate, are set at zero to 0.25% How low is that? From 1971 through 2013, the average short-term rate stood at 6.18%

Just have a look at this chart, courtesy of Economagic[1], showing the effective Fed funds rate over the last 20 years:

Fed Funds CHART[2]

Meanwhile, further out on the curve, benchmark 10-year Treasury notes are below 2%. Before the financial crisis they were above 4%. Before the dot-com bubble burst they were above 6%. Go back more than a hundred years and the 10-year averages nearly 5%.

And since Fed policy has helped boost stock, bond and commodities prices, you’d think all those things must certainly crash once this rate regime ends.

But it’s not as simple as all that.

Yes, bond prices will fall and yields will rise when rates go up, because that’s what they do. It’s unavoidable. Newly issued debt will offer higher coupons, so older debt will have to drop in price to make its yield competitive with new issues. There’s no way around it: Rising interest rates are bad for bonds prices, a key risk along with default and inflation.

However, as counterintuitive as it may seem, stocks needn’t fall when rates rise. In fact, the last two times the Fed raised rates, stocks went on to post handsome gains, according to research from Deutsche Bank.

When the Fed raised short-term rates from 2004 to 2006 — to 5.25% from 1% — stocks added 6.3% over the next 12 months, according to Deutsche Bank. The previous rate hike — to 6% from 4.76% in 1999 and 2000 — saw the S&P 500 respond with a 6% gain over the next 52 weeks.

As long as the economy is expanding when the Fed hikes, stocks should go up. As David Rosenberg, chief economist and strategist at Gluskin Sheff writes in a note to clients:

“Even when the Fed is tightening policy, so long as the economy is not contracting … the natural tendency of the market is to grind higher.”

In theory, commodity prices should fall on a rate hike. Cheap money has helped fuel speculation in the futures market, for one thing. And a rate hike should mean a stronger dollar, so commodities priced in dollars would get cheaper still.

But research shows that any boost commodities got from the Fed’s fire hose of liquidity ended some time ago. Indeed, since commodities are actual physical goods needed in the real world, they are driven more by actual demand than rate policy, write analysts at Societe Generale:

“The effect of QE on commodities (if any) vanished earlier than for equity markets. During each of the first two quantitative easing phases carried out by the Fed, commodities appreciated by over 25%. However, following the announcement of QE3 in Sept. 2012, commodity prices declined, a reminder that they remain largely driven by economic cycles rather than central bank actions.”

If there is a clear winner in a higher-rate environment, it is undoubtedly savers. Money markets, savings accounts and CDs are throwing off interest of anywhere from 0.6% to 1.8%. Bond yields are likewise pitiful. Higher rates mean that anyone with savings or holding bonds to maturity for the income (how quaint) will get more interest.

As difficult as it may be to transition out of this low-rate environment, higher short-term and long-term rates are a good thing. After years of crisis and aftermath, they should signal that the economy is back to business as usual, and maybe even healthy.

  1. Economagic:
  2. [Image]:

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