With an interest rate hike looming sooner rather than later, we thought it may be useful to look back at what happened when the Federal Reserve (Fed) raised rates the last few times.
We consider only those instances when the Fed raised the Federal Funds Rate (FFR) after more than two years of keeping rates steady, or lowering them. This criterion leaves us with only three episodes over the past thirty years, namely February 1994, June 1999 and June 2004 (data from NY Fed). It leaves out several instances of rate increases in the 1980’s that were interspersed with a drop in rates, but all of these were within a year or so of the previous rate increase.
The following graphic compares economic conditions during these episodes, particularly, inflation as measured by core personal consumption expenditures (PCE – the Fed’s preferred measure), Federal Funds target rate (effective) and unemployment rate.
How did stocks react?
As a special case, we also consider the period of the Taper Tantrum, triggered by Fed Chair Ben Bernanke’s comments to Congress in May 2013 that the Fed would likely start slowing/tapering the pace of its bond purchases later in the year. This is not a typical case of the Fed hiking rates but is the most recent instance of a stated intent to start tightening monetary policy.
The following table looks at equity market (S&P 500 Index) returns over 1, 3, 6 and 12 months after the date on which the rate hike was announced, or Bernanke’s statement in the case of the Taper Tantrum. To establish a baseline for comparison, we also looked at returns over the same periods prior to the rate hike. Note that these periods are in terms of trading days.
Interestingly, in all four cases, the S&P 500 had positive returns over 1, 3, 6-month and 1-year periods prior to the rate hike. However, we see this quickly reversed in the month following the announcement. The S&P 500 also had negative returns over the next three months in all cases except for the summer of 2013. As a reaction to the “tantrum”, the Fed set out to convince the market that an intention to taper bond purchases in 2013 was conditioned on data and would not immediately be followed by an increase in rates, resulting in an equity market rally. Over the longer periods of 6-months and 1-year, in all four instances we see that S&P 500 returns, while positive, are considerably lower than the corresponding period prior to the announcement.
To understand a little more how the market moved after, and prior to, the rate hike, we also look at the daily volatility (annualized) and maximum drawdown experienced by the S&P 500 over these same periods.
It does not appear as if daily volatility increases during the post rate hike phase compared to prior periods. In fact, volatility is slightly higher in the month preceding the rate hike, perhaps in anticipation of it, compared to the following month. A significant outlier is 2013, the month following Bernanke’s statement (triggering the Taper Tantrum).
However, the picture is a little different when we consider maximum drawdowns. The periods following a rate hike announcement typically exhibit larger drawdowns than corresponding periods prior to the announcement. This is more pronounced in the 1-3 month periods following the rate hike.
The data, limited as it is since we have only four precedents, does appear to indicate that the immediate period following a rate hike announcement (1-3 months) is accompanied by negative equity market returns and larger drawdowns than the market experienced in the prior period. However, we do see bit of a rally three months removed from the first rate hike. Note that in each instance of the initial FFR increase that we consider here, the Fed continued to raise rates at more or less the same pace over the next four to five meetings.
What happened to bond yields?
The larger impact when the Fed raises rates is potentially on bond yields – so, what did yields look like before and after rate hikes? The next table shows the yield on the US 10-year treasury on the day of the rate hike, as well as over several periods before and after.
In every case, except for 2004, the yield on the US 10-year treasury rose more than 60 basis points over the 6-month period following a rate hike announcement. In contrast, the period following the first rate hike in 2004 shows yields falling almost 60 basis points over the year. This is quite curious since the period in question was accompanied by core inflation running higher than the Fed’s 2% target and GDP (nominal) rising at an annualized rate of more than 6%. Yields eventually did rise to more than 5% by April of 2006.
For the most part, it would seem logical that the immediate period (1-3 months) following a rate hike should see interest rates rising, particularly on the short end of the yield curve, as a result of the Fed tightening monetary policy. At the same time, based on the precedents discussed above, especially the strong market reactions to the taper tantrum, equity markets may be in store for a period of negative returns and larger drawdowns in the immediate aftermath of a rate hike announcement. More so when you account for the fact that the last time the Fed raised rates was June 2006, more than nine years ago.
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