Markets Will Take A Hit If Fed Raises Rates

|
 |  Includes: AFSI, ALL, BAC, GS
by: Best Credit

Summary

Historical data reflects large stock market losses following each EFF hike.

Increased borrowing and capital costs will change company valuations.

Increased default risk leaves banks exposed during rate hikes; insurance companies stand to benefit.

Fed chairwoman Janet Yellen spoke Friday about the prospect of raising the Federal Funds Rate. During the course of her keynote address at the annual Jackson Hole symposium, Yellen revealed... well, nothing really. Raising interest rates (which remain near record lows) is something that the Fed is considering, but not yet, although possibly soon, maybe.

The markets responded to these uncertain statements by remaining cautious. The Dow Jones Industrial Average (-0.22%) and the S&P 500 (-0.20%) both dipped slightly in the following hours, although that might be attributable to news of a Russian convoy entering Ukraine.

The Fed is still concerned about a weak US recovery and uninspiring labor numbers. Nevertheless, the long-term impacts of years of astronomically low interest rates are not fully understood; at least two members of the Board of Governors have directly opposed the continuation of the Fed's low-rate, easy money policy.

While it's not clear that now is the time for a necessary rate hike (I strongly suspect that it is), what we do know is this: when the Fed raises interest rates, the stock market will take a significant hit.

History of Fed Rate Hikes

The Effective Federal Funds Rate (EFF) currently sits at 0.09 percent. This is a hugely significant interest rate, undergirding most of the major borrowing and lending decisions of financial institutions in the United States. History, logic, economic theory, and the law of averages all suggest that the rate has to increase at some point. Thanks to the magic of statistics, we can use past rate hikes to (roughly) predict the impact that will have on markets.

The Federal Reserve has increased the EFF a total of 15 times in the past 60 years. The spreadsheet below, courtesy of StreetTalkLive, organized the data in a relatively clear manner:

Click to enlarge

Why Stocks Decline After Fed Rate Hikes

There is a prominent mathematical theory which holds that interest rates are inversely correlated with the P/E ratio of all stocks. Despite very, very mixed empirical evidence to back this up, many investors hold this belief and subsequently become bearish at the sight of EFF hikes. This explains at least some of the subsequent stock market decline.

Obviously, bond valuations are impacted when interest rates rise.

More importantly, an increasing EFF has the effect of increasing borrowing costs across the entire economy. Inventories become more expensive to hold, capital costs rise, long-term projects now appear to be less profitable. Businesses who have relied on cheap lenders as a major source of financing are forced to reorganize their business efforts, casting doubt on valuations and leading to sell-offs.

Investors should be cautious of highly leveraged companies and companies that will face serious cash flow problems if their borrowers struggle in a rising rate environment.

I'll steer clear of calling this a bad thing necessarily; again, the long run impacts of near-zero EFF rates and the Fed's massive bond-purchase programs are not yet fully understood.

Strong Performers in a Rising Rate Environment

Banks and other financial intermediaries have tended to survive interest rate hikes in the past. Since they pocket the difference between what they earn on U.S. Treasuries and the rates they have to pay out on demand deposit accounts, many are able to absorb the shock. However, I don't think it's time to jump into Bank of America (NYSE:BAC) or Goldman Sachs (NYSE:GS); after all, the balance sheets for these institutions are historically unique right now, and nobody really knows what actions they will take when rates increase.

Additionally, many individual borrowers could be hurt by a rising rate environment. Real incomes have not risen enough to offset increased payments, and default risks have to be a very real concern for lending institutions.

Insurance companies could stand to benefit - their underlying investment portfolios are going to profit from rising yields. Companies like AmTrust Financial Services (NASDAQ:AFSI) and AllState (NYSE:ALL) have had solid showings for years, although recent dips highlight potential buying opportunities.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.