Download What Does a Fed Tightening Mean for Equities?

What Does a Fed Tightening Mean for Equities?
September 2014
Six years after the Financial Crisis peaked in the fall of 2008, equity markets have fully recovered and reached new
highs, and interest rates remain near historical lows. Meanwhile, the economy is mired in a slower than normal
expansion, the slowest in the post-war era.
Following an unprecedented period of monetary accommodation, the Federal Reserve is preparing investors for a
normalization of interest rates starting in 2015, signaling the end of near zero short-term interest rates imposed since
December 2008. With interest rates poised to move higher, we look back at previous instances of the Fed hiking
interest rates after extended periods of easy monetary policy.
1994-1995
After a series of rate cuts from 1989 to 1992 lowered the Federal Funds rate from 9.75% to 3.00%, the Fed kept rates
steady for 17 months into early 1994, at the time an unprecedented period of low interest rates. In February 1994, the
Fed began a series of rate hikes that would increase the Federal Funds rate to 6.00% over 12 months. This resulted
in a rout of the bond market, which had thrived on low short-term rates and a steep yield curve, a policy intended to
heal the banking system after it suffered severe real estate losses in the early 1990s.
While the bond market tanked due to the 1994 rate hikes, what happened to stocks? The S&P 500 declined about
8.7% during the first two months following the first rate hike in February 1994. Share prices stabilized and moved
sideways in a narrow range the rest of the year, with the S&P 500 closing the year nearly 5.0% above its low point
reached in April 1994. The stock market was able to shrug off the aggressive tightening of monetary policy because
the economy was strong. Stocks went on to enjoy a banner year in 1995, with the S&P 500 posting a total return of
over 37%. The central bank had successfully engineered a soft landing by tapping on the brakes without steering the
U.S. economy into recession. The economic expansion endured for the rest of the 1990s as monetary policy remained
generally steady through the end of the decade. The S&P 500 gained 243% from the first rate hike in February 1994
to December 1999.
2004-2006
The bursting of the technology stock bubble in the early 2000s led to three years of declining stock prices yet merely
a mild economic recession in 2001. The Federal Reserve, led by Alan Greenspan, slashed interest rates dramatically,
taking the Federal Funds rate from 6.50% at the end of 2000 to 1.00% by mid-2003. Similar to the early 1990s, the
Fed kept rates steady for a year until it became apparent that the extraordinarily low level of interest rates was no
longer appropriate. Starting in June 2004, the Fed increased interest rates 17 times in increments of 25 basis points
over the next two years. Once again, stocks dipped in the weeks following the first rate hike, with a decline of over
6.5% in the S&P 500 by mid-August 2004. Stocks rebounded 14% from the low point in August to year-end. The
total return in the six months following the first rate hike was 7.2%. Stocks then generated positive returns in 2005
(4.9%), 2006 (15.8%), and 2007 (5.5%).
End of Quantitative Easing
In reviewing the current cyclical recovery, since the equity markets bottomed in March 2009, large cap U.S. stocks
have been the most rewarding investment asset class, with the S&P 500 Index producing a total return of 177% from
March 31, 2009 to September 30, 2014. International stocks have rebounded somewhat less, with a total return of
113% for the MSCI EAFE Index. Bond yields have fluctuated, with the 10-year U.S. Treasury Note starting the period
at 2.70% and peaking just below 4.00% in April 2010, then plunging to a low of 1.40% in 2012. The yield on the 10year Treasury was 2.49% on September 30, 2014.
What Does a Fed Tightening Mean for Equities?
(continued)
Many have noted that stocks declined after the Fed’s previous quantitative easing (QE) programs concluded and
predict that the winding down of QE3 will inevitably lead to a slump in stock prices. Indeed, the Federal Reserve has
expanded its balance sheet by over $3.5 trillion since 2008, which has lifted asset prices in both equity and fixed
income markets. After QE1 ended in March 2010, the S&P 500 declined 11% over the next 3 months. By November
2010, the Fed had commenced a second program of “large scale asset purchases” that added $600 billion in bonds to
the Fed’s balance sheet over an 8 month period. By the end of QE2 in June 2011, the S&P 500 had posted a positive
total return of 13%. After the monetary stimulus of QE2 ended, the S&P 500 lost 14% over the next 3 months.
By December of 2012, the Fed was still seeking improvement in the unemployment rate and higher inflation. The
central bank announced QE3, an open-ended program to buy $85 billion per month of Treasury bonds and agency
mortgage-backed securities. This program was again successful at elevating stock prices and was largely responsible
for the roaring bull market of 2013 as the S&P 500 gained 32%. The only hiccup occurred in the summer of 2013
when Ben Bernanke hinted that at some point the bond buying program would be curtailed. The resulting “taper
tantrum” saw an increase in market volatility, yet no sustained drop in equity prices. Bond yields climbed during the
second half of 2013 as investors anticipated the eventual tapering of QE3. By the time the tapering began in January
of 2014, the Fed had done plenty to signal this to investors, and market volatility has been muted for much of the
first nine months of 2014.
2015-?
Now that QE3 is poised to end in the coming weeks, the Fed will be signaling under what conditions it may act to
normalize interest rates. The markets are discounting the first rate hike by mid-2015. Fed officials are not united in
their views, with the hawks opining that policy should be normalized swiftly to prevent asset bubbles. Meanwhile, the
doves want to foster improvement in labor markets by leaving monetary accommodation as long as possible. With
the Fed’s own economic forecasts consistently too optimistic, and inflation stubbornly below 2.0%, the Fed may end
up keeping rates lower for longer, a refrain that we have heard often for past six years.
If recent history is prologue, equity prices will likely exhibit another bout of volatility surrounding the next anticipated
rate hikes, whenever that happens. However, like the 1994-95 and 2004-06 time periods, the next Fed tightening
does not necessarily have to signal an end to higher stock prices. In fact, during the post-war period, stocks (as
measured by the S&P 500) have not peaked until 18 months on average after the start of the Fed’s tightening cycle.
Though there is no guarantee that history repeats itself this cycle, as Mark Twain once said, “it does rhyme.”
The Arrington Building
804.288.0404
1802 Bayberry Court
800.787.7414
Suite 400
FAX 804.288.7872
Richmond, Virginia 23226
www.lowebrockenbrough.com