Download What to Expect From Rising Interest Rates

April 2015
What to Expect
From Rising Interest Rates
“The question of
whether the Federal
Reserve will raise
interest rates is one of
when, not if. At
Goelzer, our research
suggests an initial
increase in the federal
funds rate is likely to
occur this calendar
year, and we are
positioning your
portfolio accordingly.”
A History of Interest Rate Changes
Markets have been hypersensitive to comments made by members of the
Federal Open Market Committee (FOMC). Such attentiveness to this
interest-rate-setting branch of the Federal Reserve is focused on the belief
that its members are poised to increase the target federal funds rate (an
overnight lending rate used by banks) which they first lowered to 0% over
six years ago. Or are they? The FOMC’s ambiguous comments regarding
the timing of such a policy change has kept investors guessing and markets
increasingly volatile.
Our read of the FOMC members’ comments leads us to believe that one or
two increases in the federal funds rate are likely this year. Should this be
the case, the important question to be answered is, “What will it mean for
your portfolio?”
To answer that, we took a look at the history of federal funds rate increases
over the past 40 years as depicted in Figure 1. The chart shows that
unlike the past six years, interest rate changes by the FOMC in prior years
were very common. In fact, from 1975 through 2008 there was only one
year, 1993, during which the FOMC did not make at least one interest rate
change. Increases in the federal funds rate occurred during 15 of those
calendar years. It is on those years that we will focus our analysis.
FIGURE 1
J. Andrew Concannon, CFA
Chief Investment Officer
[email protected]
317 264- 2600
www.goelzerinc.com
FIGURE 2
The Impact of Rising Rates on Bond Prices
Will Stocks React Negatively?
In the past, bond yields typically rose in response to
federal funds rate increases. Yields on shorter-maturity
securities, as represented by 1-year U.S. Treasury bills,
rose during 12 of the 15 years in which the target rate
was increased. The average yield increase during those
years was 1.8 percentage points with a range of 0.6 to
3.6. The results were similar but less pronounced for
longer-maturity bonds, as yields on 10-year U.S.
Treasury bonds rose during 11 of the 15 years with an
average yield gain of 1.2 percentage points and a range
of 0.2 to 2.1.
Many stock market forecasters believe that interest
rate increases will lead to declines in stock prices.
This, however, is not supported by our research. As
shown in Figure 2, the stock market, as measured by
the Standard & Poor’s 500 Index®, actually provided
a positive total return for 13 of the 15 calendar years
during which the FOMC raised rates.
While the impact of an increase in the federal funds rate
has typically been greater for shorter versus
longer-maturity yields, what is important to note is the
price change on the underlying securities. As a general
rule, shorter-maturity bonds are impacted less by
changes in yield than are longer-maturity bonds. For
example, the price of the current 3-year U.S. Treasury
note would fall by 2% if the yield a year from now were
one percentage point higher. By contrast, the current
10-year U.S. Treasury bond would experience a nearly
8% price decline under the same scenario. Thus, by
investing in shorter maturities investors can reduce the
hit to principal value caused by rising rates. We are
employing this strategy by shortening our target maturity
range to 1 to 6 years versus our usual range that
stretches to 12 years.
Clearly other factors outweigh the impact of higher
rates when it comes to stock prices. Most important
among them are earnings growth and valuation levels.
Large stock market declines are typically the result of
falling earnings, high valuations, or a combination of
the two. The FOMC’s interest rate increases
historically occurred during periods of earnings growth
which gave support to higher stock prices.
Whether the stock market rises or falls in response to
the next interest rate increase will be known only in
hindsight. Rather than trying to predict the
unpredictable, the objective should be to build a
portfolio that can withstand the market’s ups and
downs in order to meet your long-term goals. At
Goelzer we do that through a disciplined focus on
diversification, quality, earnings, and valuations.
The information provided in this material should not be considered as a recommendation to buy, sell or hold any particular security. This report includes candid statements and observations
regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be
correct. Actual results may differ materially from those we anticipate. The views and strategies described in the piece may not be suitable to all readers and are subject to change without
notice. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. The information is not intended to provide and should not be relied
on for accounting, legal, and tax advice or investment recommendations. Investing in stocks involves risk, including loss of principal. Past performance is not a guarantee of future results.
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