The Fed is Ready for Take-off


It seems nearly impossible not to have heard that the Federal Reserve (Fed) has started raising rates. Technically, the Federal Reserve raises the Federal Funds Rate. That is the rate that the Fed charges commercial banks (Citigroup, Bank of America, etc) when they are borrowing or lending their excess reserves to each other overnight. This in turn can have a significant impact on consumer loans and credit cards.

The U.S. Treasury yield curve is used as the benchmark for the credit market because it displays the yields of risk-free income instruments over a range of varying maturities. As stated above, when the Fed raises the Fed Fund Rate, credit markets, banks, many lenders will use the Treasury yield curve to determine lending and savings rates. Therefore, when the Fed raises rates, all lenders tend to do so in unison, although the rate increases will likely be inconsistent across market participants.

As we have seen over the past decade or so, low interest rates and massive fiscal stimulus drove investors to riskier assets such as stocks. However, when there is an alternative investment that provides a higher return than previously with less risk, investors will recalculate their risk position. When the Fed met on the 15-16 March 2022, they decided to raise rates by 0.25%. This was the first of potentially six rate increases as stated by Jerome Powell, Chair of the Federal Reserve.

What happens to stocks with interest rate increases? Historically, the lead-up to the increase is a difficult time in the equity markets. We have certainly seen the signs of that; however, when rates are increasing, it has generally been good for stocks, all else being equal.

The chart below shows that initial rate increases by the Fed have had positive impacts for both stocks and bonds. Intuitively, if the Fed is increasing rates, that means the economy is doing well. The increases are to slow, not stop, the economy. What we have seen in the US is exactly that; an economy that is robust, even in the face of higher inflation.

In the lead up to rate increases, we find that growth stocks tend to be hit harder than value companies. Growth stocks (typically Tech stocks) are characterized by higher price-to-earnings (P/E) ratios. As rates rise, future growth is discounted back to the present value and would therefore, be worth less. This is the exact reason the NASDAQ (Tech heavy index) is off -12.10% (as of 28 Feb 2022 according to Yahoo finance) and the S&P 500 is down -8.23% (as of 28 Feb 2022 according to Yahoo finance) for the year-to-date.

As is the case in any market convulsions, it is imperative to rely on your investment plan and ensure you are in a well-diversified portfolio. It is impossible to game the market and no one person knows which sectors, styles or factors will out- or under-perform and for what duration. Therefore, diversification rules will be the guidepost for a successful investment journey.

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