Discount Rate Past Is Not a Predictor of the Future

| About: SPDR S&P (SPY)

A few months ago, we were warned by the Fed that the borrowing rate will increase with “greater force than is customary”… then they waited a few long months to act on the warning. So should we, as investors, be surprised? Not really, we expected it. But in order to appreciate the effects of the increase, it’s handy to look at how rate increases from the Fed impacted investors’ demeanor in the last century.

Some research shows that the Federal Reserve took on 13 rate increases since mid-century (specifically longer-term programs that lasted approximately 2 years, not just individual one-time rate increases; this increase was likely the first of many in the 2010, 2011 period). The research also showed that the reactions of the markets weren’t as extreme as one might first imagine. And it makes sense that the current rate increase won’t have an extreme market reaction considering we were “expecting” a force “greater than is customary” – an oxymoron in itself.

Looking at the graph below, you can use S&P 500-movement in all years since the 1940s as a benchmark for how the market coped with Fed rate changes. On the same line of thought, this is how the market also traveled with economic cycles, assuming the Fed’s policies are relatively consistent across economic cycles. For example, rate increases, implying the present day situation, pertain to periods where the Fed wanted to fight inflation, where economic conditions show signs of improvement, and so forth.

As evident on the graph, although periods of rate decreases are associated with significant increases in equity levels, periods of rate increases are not too far from the average. It still seems that rate increases acted as a slight hurdle for equity price increases, but on the whole investors still saw positive movement.

The big question – will the markets continue to rise in the next 2 years and continue their historic pattern? No way; this graph is going to get contorted. I argue that after the incredible amount of debt the US has incurred, no level of discount rate is high enough to battle the potential inflationary pressures that could arise. The graph has one, huge problem – it does not account for events off the scale of ordinary.

The bottom line – will today’s expected rate increases have minimal effects on equities? Yes, but only because the Fed has no control over the way money will inflate in that time span. No control and no idea of what’s coming their way.

Disclosure: Short market