What Assets Return When The Fed Raises Rates

How have various asset classes performed when the Federal Reserve begins tightening by raising short-term interest rates.

In this episode you’ll learn:

How interest rates have declined over the decades.
What determines interest rates.
What are different measures of inflation.
How long after the first Federal Reserve begins raising its policy rate have recessions begun.
What have stocks, bonds and other asset categories returned one year after the Federal Reserve begins raising interest rates.
How to use duration and yield to estimate bond returns when interest rates rise.

Show Notes

Episode 52: Why Are Interest Rates So Low and In Some Cases Negative – Discusses the four factors that drives the level of interest rates.

Tyler Davidson Fountain

Become a Better Investor With Our Investing Checklist

Become a Better Investor With Our Investing Checklist

Master successful investing with our Checklist and get expert weekly insights to help you build your wealth with confidence.

This site is protected by reCAPTCHA and the Google Privacy Policy and Terms of Service apply.

Summary Article

Is It Time To Tighten?

For a time during the late 1970s, my mom —as a single parent—was a real estate agent. She worked for my uncle’s real estate brokerage.

In order to transport her clients to showings, she bought a new 1977 Dodge Aspen sedan in a respectable tan with an interior the color of peanut butter

My uncle’s real estate firm was called Properties Unlimited, and given the economic environment it was a fitting name. There was an unlimited supply of homes for sale because most people couldn’t afford to buy one given the double-digit mortgage rates.

The yield on the 10-year U.S. Treasury bond peaked in 1980 at 15.3%. By then, my mom had given up on home sales after selling very few. She would eventually pursue a more humble business involving real estate: cleaning houses.

High Interest Rates Were The Norm

Fortunately, interest rates are no longer double digits. Instead, interest rates have been so low for so long it is difficult to remember how high they were and how long it took before they fell.

While interest rates peaked in 1980, the yield on the 10-year Treasury bond still fluctuated between 11% and 13% in 1983. By then, the exterior of our 1977 Dodge Aspen was mostly rust.

The 10-year Treasury yield was 9% four years later in 1987, and the Dodge had large gaps in the side panels where the rust had disintegrated. My mom eventually sold the car for $200 and bought a Honda Accord in mint green.

In 1991, more than a decade after the peak in interest rates, the yield on the 10-year Treasury bond was still 8%. That was considered normal.

Low Rates Are The New Normal

Nine years later, Mohammed El-Erian, who was co-Chief Investment Officer at the investment firm PIMCO at the time, would coin the phrase the “new normal” to describe the economic regime that has been in place the past six years: Slow, but positive economic growth, low inflation and very low interest rates.

In 2012, the yield on the 10-year Treasury hit a generational low of 1.5%. It was still a little over 2% earlier this year, and other countries around the world issue 10-year government bonds at yields of well below 1%.

Interest rates have been extremely low because inflation has been low and because there is a persistent demand for government bonds from investors who are willing to give up yield for safety.

Another reason U.S. interest rates have been so low is the Federal Reserve has kept its short-term policy rate at close to zero for over six years.

Longer-term interest rates are influenced by the expected level of short-term rates several years out, and with the Federal Reserve having shown no indication of raising its short-term target rate, longer-term interest rates have stayed low.

Normalization?

Except now it appears the Federal Reserve will finally start to normalize its monetary policy by raising the short-term interest rate target. They could start as early as next month.

The Federal Reserve’s process for gradually raising its policy target rate is called tightening.

The Fed by incrementally raising its short-term interest rate target and by communicating where it believes the policy target rate will be next year and several years out can cause longer-term interest rates to rise, which makes it more expensive for companies and households to borrow, leading some of them to choose not to do so.

Less borrowing means slower economic growth. Slower economic growth means a lower risk of inflation, which is one of the Federal Reserve’s mandates—price stability.

The other mandate is full employment and with the unemployment rate back at 5% the Fed has hinted that it is time to tighten so if and when the U.S. economy faces a recession the central bank will have room to cut its policy target in order to loosen it monetary policy and stimulate growth.

Negative Rates

When short-term rates are zero, it is difficult to lower them further, although the European Central Bank has shown that it is possible to orchestrate negative interest rates.

Negative interest rates occur when the demand for government bonds is so great that investors are willing to pay more for them than what they will eventually receive in interest and principal payments.

Given it has been over a decade since the Federal Reserve pursued a tightening policy, investors are understandably worried what the impact will be on their investment portfolios.

Stock and Bond Returns

How have stocks and bonds performed historically when the Federal Reserve has begun to tighten?

According to Ned Davis Research, the median return for U.S. stocks, as measured by the S&P 500 Index, one year after the Federal Reserve has begun to raise its short-term policy rate was 6.5%.

During periods when the Fed raised rates slowly and in very small increments, as they will most likely do this time, the median return for U.S. stocks was over 17% one year later.

Bond market returns have also been positive during periods of Federal Reserve tightening with the Barclays U.S. Aggregate Bond Index, a measure of the overall bond market, experiencing median total return of 7.7% in the year after the Fed began tightening.

The return for bonds will be nowhere near that level this time because interest rates are already so low.

Investors who hold 10-year Treasury bonds have very little interest income to offset the price losses for those bonds that will accompany a rise in longer-term interest rates.

One way to avoid those potential bond losses is to hold a fund or ETF with a shorter average maturity and with a higher yield.

Those higher yields are achieved by investing in non-government bonds, which introduces other risks including credit and default risks.

Investing always involves trade-offs.