Rising Rate Redux
Rising short term interest rates are ahead of us in 2022. The Federal Reserve (Fed) in the U.S. and the Bank of Canada are both poised to raise their benchmark rates. Current expectations are for the Fed to make the first of a series of increases to the Federal Funds rate in March. If this happens, we have plenty of precedents to look back on. As I said in my first blog in 2020, history is no mystery and gives us guidance on how the stock markets may react.
Hiking History
The Federal Reserve, through its control of the Federal Funds Rate (Fed Funds), has a significant impact on U.S. and global stock markets. It can undertake easing cycles (decreasing Fed Funds) or tightening cycles (increasing Fed Funds). Based on research from the Federal Reserve Bank of New York, Table 1 shows that since 1980 there has been seven tightening cycles. I have chosen this period as the “modern” era of monetary policy. On average the time between the first and last increase in Fed Funds is 20 months. The average increase is 4.74%. The average increase in Fed Funds in the epoch of lower interest rates (since the 1990’s) is 2.8%.
Table 1
Source: Federal Reserve
Rising Rate Returns
Other than the obvious fact that short term rates increase during a tightening cycle, what is the impact on stock returns? To answer this question, I used month end total return indices for U.S. stocks (S&P 500) and Canadian stocks (S&P/TSX). The returns for the S&P are shown in U.S. dollars (US$) and Canadian dollars (C$) for comparison to the TSX. The returns in Chart 1 below were calculated by taking the index levels at the month ends around the start and end dates of the tightening cycles.
Chart 1
Sources: Yahoo Finance, investing.com
Despite rising Fed Funds stock markets did well. This isn’t unexpected as the increases in Fed Funds have generally occurred when the economy was doing well. Also, over time stocks have typically gone up due to rising earnings. Looking at the first set of bars, the S&P in US$ had a positive return during all seven tightening cycles. The average return was 9%. The S&P in C$ also had an average return of 9% but had a small loss of -2% during the 2004-2006 cycle. The TSX had a higher average return of 12%, but the returns were more volatile. There was a -7% return in the 1994-1995 cycle and a huge 38% return in the 1999-2000 cycle in the glory days of Nortel.
Pre Post Patterns
In Chart 1 we looked at how the S&P and TSX perform during a tightening cycle. Now let’s look at how they fare in the months pre and post the first increase in Fed Funds (1st hike). Return calculations were done with month end data. Chart 2 below shows the average of the total return indices for the seven tightening cycles for the S&P in US$ and C$ and the TSX in C$. The time scale is from six months prior to the 1st hike to twenty-four months after. At the time of the 1st hike the return index based at 100. This is indicated by the vertical line at month zero.
Chart 2
Sources: Yahoo Finance, investing.com
After squinting at the lines there are some takeaways. First, the dominant trend is that all the average return indices generally increased until nine months after the 1st hike. The average return from the 1st hike to month nine was 13% for the S&P US$. All seven cycles (individual S&P and TSX cycles are not shown) had positive returns. The average return for the S&P in C$ was a little lower at 11%. Only the 2004-2006 cycle had a negative return of 5%. The TSX average return was a robust 18%, with only the 1994-1995 cycle having a negative return of 4%.
The second takeaway is two patterns of small negative returns. The S&P and TSX average return indices had a small decline from month five to month four before the 1st hike. There was a 2% decline in the S&P US$, with five of the seven cycles having small negative returns. The S&P C$ had a 1% decline with four of seven cycles mildly negative. The TSX fell 4%, with five of the seven cycles having small negative returns.
The second negative return pattern was after month nine. The S&P US$ declined in all the cycles from month nine to ten, with an average decline of 2%. By month twelve the average decline peaked at 5%, although only five of seven cycles were lower than at month nine. The loss for the S&P C$ was negligible. The TSX average return declined 4% from month nine to eleven, although only four cycles were lower than month nine.
Daily Deep Dive
Chart 3 does a deeper dive with higher frequency data. I replicated the average indices for the S&P US$ using intraday price data. For the TSX I used daily total return data. The average indices were calculated using the minimum price (S&P) or total return (TSX) in each month pre and post the 1st hike. At month zero (index level of 100) I used the closing price or return index on the day of the 1st hike. I used the minimums to highlight the downside risk.
Chart 3
Sources: Yahoo Finance, investing.com
The general upward trends until month nine are similar to those in Chart 2, while the declines are a little bigger. The S&P US$ average price index declined by an average of 5% in the month after the 1st hike. All seven cycles declined. From month nine to eleven the average decline was 6%. All seven cycles declined from month nine to ten and five cycles declined from month nine to eleven. The TSX average return index had six of seven cycles with declines in the month after the 1st hike, with an average fall of 2%. From month nine to eleven there was an average decline of 5%, with five of seven cycles declining.
Rising Rate Returns Review
There are lots of numbers in this Rising Rate Redux, so let’s review the main findings. First, the S&P and TSX on average posted positive returns during Fed tightening cycles. Looking closer at the data, the upward trend has been your friend from four months prior to the 1st rate hike to nine months after. The S&P was higher at month nine across all the cycles, while the TSX was higher in six of the cycles.
The second finding is that in all the cycles the S&P in US$ fell slightly in the month after the 1st hike and from month nine to ten. The TSX also showed similar patterns, albeit with less consistency across the seven cycles. These patterns are based on using the minimum price or return index levels each month.
The conclusion is, unsurprisingly, that if the Fed starts a tightening cycle as expected in March, history says stay invested in stocks instead of trying to time the market. But be aware that there have been common times when there have been mild to moderate setbacks in returns, especially nine months after the 1st hike.
Invest Wisely,
Dave Schaffner, CFA
Principal, Wayfairer Capital Management Ltd.