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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. Goelzer INVESTMENT MANAGEMENT Rese a rch Relationships Results Chase Tower, Circle Building 111 Monument Circle, Suite 500 Indianapolis, IN 46204 T 317.264.2600 F 317.264.2601 [email protected] www.goelzerinc.com