How Will Stocks React?

How Higher Rates Are Affecting Bonds The Federal Reserve has taken a measured approach to communicating its policy intentions, allowing the market to lead rather than trying to guide it with specific forecasts. That dynamic appears to be playing out as the market has already priced in much of the expected rate increase. Over the past month, the two-year Treasury yield has increased 46 basis points, the one-year yield has risen 34 basis points, and the three-month Treasury yield, which is closely tied to the federal funds rate controlled by the Fed, has increased 24 basis points. This represents a relatively healthy relationship between the Federal Reserve and the markets, with market expectations pulling the Fed forward rather than the Fed pushing markets in a particular direction. Traditionally, the Fed raises interest rates to slow economic growth and reduce inflation. The challenge this time is that inflation is being driven largely by higher oil prices rather than excessive economic growth. As a result, higher interest rates could slow economic activity while elevated oil prices are putting additional pressure on consumers. For consumers, that could create a double impact. Higher oil prices can reduce disposable income, while higher interest rates increase borrowing costs. For investors, however, higher rates can provide a benefit. Interest rates represent what borrowers pay, but that interest is income for investors. With roughly $7 trillion in money market assets in the U.S., a 25-basis-point increase would provide a meaningful boost to interest earned by savers. Ultimately, higher rates are likely to be a net positive for savers and a net negative for borrowers. How those effects ultimately flow through to the stock market will be important to watch. What History Tells Us About Stocks History can provide some perspective on how stocks have responded to previous Federal Reserve tightening cycles. Looking at the S&P 500 following the initial rate hikes across the six tightening cycles since 1994, stocks have generally struggled during the first several months following the initial increase. On average, returns were negative through the first four months before improving significantly five to six months after the initial hike. However, there have been notable exceptions. Following the initial rate hike in March 2022, the S&P 500 fell over the subsequent two months and remained down for more than 12 months. That period presented a uniquely difficult backdrop, with long-term interest rates rising from historically low levels as inflation surged to multi-decade highs following the pandemic. The Federal Reserve was forced to tighten aggressively after initially viewing inflation as transitory. Its history of continuing to raise rates until something breaks also contributed to fears that a recession was approaching. The stock market ultimately experienced a roughly 25% drawdown, consistent with the kind of decline investors might expect during a recession, although the U.S. economy did not technically enter one in 2022. The environment today is notably different. Another important exception occurred in 1997. Stocks significantly outperformed the other tightening cycles, with the S&P 500 gaining nearly 8% two months after the initial hike and approximately 42% one year later. The dot-com boom and optimism surrounding the internet helped propel stocks higher despite rising interest rates. That period offers an interesting comparison to today’s environment, where enthusiasm surrounding artificial intelligence plays a similar role. Revolutionary technology can, at least for a time, outweigh the effects of higher interest rates. Another rate hike in 1999 was followed by another strong 12-month gain in the S&P 500, illustrating how long the technology bubble continued to inflate before eventually bursting in 2000. The key lesson from these historical cycles is that rate hikes do not necessarily derail bull markets. The picture changes when rising rates coincide with increasing recession risk. Today, recession risks remain relatively low. Economic growth is solid, the labor market remains healthy, and while inflation is still elevated, it is well below the levels seen in 2022. At the same time, interest rates have already moved substantially higher, which may reduce the shock to bond portfolios from additional modest increases in market-based rates, such as the 10-year Treasury yield. While history does not provide a perfect blueprint for what comes next, today’s combination of economic resilience and moderating inflation looks more like the late 1990s than the challenges of 2022. That does not mean investors should expect another 40% rally. It does suggest that the current economic backdrop remains supportive for equities, even if markets experience volatility in the weeks and months ahead as investors continue to assess the Federal Reserve’s path.   Greg Powell, CIMA® President and CEO Wealth Consultant Email Greg Powell here Bobby Norman, CFP®, AIF®, CEPA® Managing Director Wealth Consultant Email Bobby Norman here Trey Booth, CFA®, AIF® Chief Investment Officer Wealth Consultant Email Trey Booth here Ty Miller, AIF® Vice President Wealth Consultant Email Ty Miller here   Fi Plan Partners is an independent investment firm in Birmingham, AL, with a team of professionals serving clients across the nation through financial planning, wealth management and business consulting. The team at Fi Plan Partners creates strategies in the best interest of their clients using fee based investing. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Economic forecasts set forth in this presentation may not develop as predicted. No strategy can ensure success or protect against a loss. Stock investing involves risk including potential loss of principal. Securities and advisory services offered through LPL Financial, Member FINRA/SIPC and a registered investment advisor.The post How Will Stocks React? first appeared on Fi Plan Partners.