Market Bulletin. July 30, Preparing for Liftoff: The impact of rate hikes on stock returns

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1 July 30, 2014 Preparing for Liftoff: The impact of rate hikes on stock returns James C. Liu, CFA Global Market Strategist J.P. Morgan Funds Anthony M. Wile Global Research Analyst J.P. Morgan Funds Tai Hui Chief Market Strategist - Asia J.P. Morgan Funds Overview The federal funds rate has remained at the zero lower bound since the Federal Reserve s last rate cut in An improving economy suggests that the target rate is likely to rise in Due to the data dependent nature of monetary policy, rate hikes often occur alongside improving economic growth. History shows that while equities may slightly underperform immediately following rate hikes, they recover quickly and subsequently outperform as a result of positive economic fundamentals. The Fed s use of forward guidance should reduce rate hike surprises once initial expectations are established. Rate hikes that are expected by the market typically have little impact on stock returns. As a result of these findings, we believe that an overweight to U.S. equities continues to make sense. Introduction Six years after the onset of the global financial crisis, the Federal Reserve is likely to begin raising the federal funds rate in This will be the first change to the target rate since December 2008 when the Federal Open Market Committee (FOMC) lowered it to the zero bound and began using unconventional monetary policy tools. 1 Many investors are worried about the impact that rate hikes will have on the U.S. stock market. Due to the data dependent nature of monetary policy, steady rate increases have historically been associated with periods of economic improvement and strong market rallies. While equities may slightly underperform immediately following a rate hike, they subsequently outperform over longer time horizons. Additionally, the use of forward guidance should help to minimize surprise rate hikes and further reduce the impact on stock returns. This suggests that there is little reason to fear measured rate increases in isolation. In this bulletin, we review the historical record of rate decisions, carefully examine the impact of fed funds rate hikes on stock returns, and explore the implications of forward guidance on upcoming monetary tightening. As a result of our findings, we continue to favor an overweight to U.S. equities. 2 1 The last rate hike occurred in July 2006 when the fed funds rate was raised to its pre-crisis peak of 5.25%. 2 For more on this, please see our recent paper titled A cautious continuation of an equity overweight by David Kelly and Anthony Wile.

2 Figure 1: Fed Funds Rate Target and S&P 500 Index Level 2,000 1,800 1,600 1,400 1,200 Fed Funds Rate (RHS) 7% 6% 5% 4% 3% 1, S&P 500 (LHS) 2% 1% 600 '97 '00 '03 '06 '09 '12 Sources: Standard & Poor s, Federal Reserve, J.P. Morgan Asset Management. For Figure 2: Rate Increases and S&P 500 Returns illustrative purposes only. Data are as of 7/29/14. Data Dependency The Fed s data dependent approach, (i.e. the adjustment of monetary policy based on economic conditions) implies that the Fed will only raise rates if the economy is healthy and improving. As a result, Figure 1 shows that rate hikes typically do not occur in isolation, but rather as a series of measured moves alongside economic growth. The rate hikes during the 1990s and the mid-2000s followed this pattern and coincided with strong bull markets. For example, as shown in Figure 2, the FOMC raised the fed funds rate in 25 basis point (bp) increments over 17 consecutive meetings during the bull market rally from 2004 to The market performed well during this period, returning 16% on an annualized basis. It is important to emphasize that the data dependent nature of rate hikes means that there is correlation, but not causation, between higher fed funds rates and stock returns over these periods. Both are a result of stronger economic fundamentals. Period S&P 500 Total Return (Ann.) Number of Rate Hikes Beginning Rate Sources: Federal Reserve Board, Standard & Poor s, J.P. Morgan Asset Management. For illustrative purposes only. Data are as of 7/29/14. Peak Rate % % % The Impact on Stock Returns By examining rate decisions from 1989 to 2008, it is possible to estimate their effects on equity markets. 3 However, caution is warranted since it is easy to over-simplify the analysis and draw faulty conclusions. Specifically, many investors are concerned about rate hikes due to results such as those in Figure 3. This cursory analysis relates changes in the fed funds rate to subsequent stock returns and suggests that a 25 bp fall/rise in the federal funds rate results in a 54 bp rise/fall in stocks over the following week on average. 0% More recently, the relationship between the fed funds rate, the economy and equity markets has diverged due to the Federal Reserve s unprecedented use of quantitative easing. However, we believe the forthcoming rate increases will occur during a period of slow but improving economic fundamentals, with strong earnings growth and markets that are still at average valuation levels. Given this backdrop, the effect of measured fed funds rate increases on the market is likely to be similar to that of the past two decades. There are three critical issues that this analysis fails to address. First, there is a wide range of outcomes that is obscured by the analysis in Figure 3. Figure 4 plots each rate change against subsequent one-week S&P 500 returns. The significant variation around the trend line is evident. For example, rate increases of 25 bps resulted in one-week returns as high as 4.6% (March 21, 2000) and as low as 3.9% (March 25, 1997). Given the multitude of factors that affect stock returns, it is difficult to predict, with a high degree of certainty, how any particular rate change will affect stocks. 3 There were 87 distinct federal funds rate decisions by the FOMC and 120 additional FOMC meetings with no rate moves over this period. From the data points that are potential outliers, we have excluded 9/17/2001 from our analysis. See Bernanke and Kuttner (2004) for more details. 2

3 The second and more important issue with the analysis shown in Figure 3 is that the existence of this negative relationship depends on the outsized effects of rate cuts. It makes sense that the market exhibits asymmetric responses to rate hikes and cuts since the former generally occur during slowly improving periods, while the latter often occur in response to swiftly deteriorating conditions. As a result, rate drops tend to be larger in magnitude than rate hikes and have a larger effect on stock prices as well. Instead, with the fed funds rate at the zero lower bound, it makes more sense to focus on rate hikes, as shown in Figure 5. Although forward one-week returns are still negative, each rate increase of 25 bps results in only a 10 bp decline in stocks that is not statistically significant. Furthermore, one- and three-month returns are positive on average precisely because rate hikes tend to occur in rising markets. Thus, the direction and context in which rate changes occur are important. Unlike the results in Figure 3, focusing exclusively on rate hikes results in much smaller immediate impacts and much larger intermediate-to-longer-term equity outperformance. Figure 4: Fed Funds Rate Target Changes and S&P Week Total Return S&P Week Total Return 6% 4% 2% 0% -2% -4% -6% -8% -10% -0.8% -0.3% 0.2% 0.7% Target Fed Funds Rate Change Sources: Standard & Poor s, Federal Reserve, J.P. Morgan Asset Management. For illustrative purposes only. Data are as of 7/29/14. Figure 5: Average S&P 500 Performance (increases only) , average response to a +25bps increase in the fed funds rate Figure 3: Average S&P 500 Performance (increases and decreases) , average response to a +25bps increase in the fed funds rate 0.8% 1.6% 1.4% 1.43% 0.6% 0.56% 1.2% 1.0% 0.93% 0.4% 0.8% 0.2% 0.6% 0.0% 0.4% 0.2% -0.2% 0.0% -0.4% -0.2% -0.10% 1 Week 1 Month 3 Months -0.6% -0.54% -0.49% 1 Week 1 Month 3 Months Sources: Standard & Poor s, Federal Reserve, J.P. Morgan Asset Management. For illustrative purposes only. Average payoffs are calculated from increases in policy rates only. Data are as of 7/29/14. Sources: Standard & Poor s, Federal Reserve, J.P. Morgan Asset Management. For illustrative purposes only. Average payoffs are calculated from both increases and decreases in policy rates. ** 1 week payoff is statistically significant at a 1% level. Data are as of 7/29/14. 3

4 Forward Guidance The third issue not addressed by Figure 3 is forward guidance, an important addition to the Federal Reserve s policy tools. Forward guidance allows the FOMC to influence markets by setting expectations of future policy. As a result, credible forward guidance should minimize surprises in fed funds rate changes such that any change that does occur should already be reflected in market prices. We can test this pattern by separating the effects of surprise and expected rate changes using historical data from the fed funds futures market. For instance, if fed funds futures signal a 25 bp rate hike prior to the Fed s announcement but a 50 bp rate hike is subsequently announced, there is a 25 bp surprise. As shown in Figure 6, surprise rate moves explain negative stock market reactions over weekly and monthly time horizons and are statistically significant. In contrast, expected rate moves only have an effect over a one-week period. Longer time horizons have little impact or are positive for the reasons previously discussed. The stock market may experience higher levels of volatility when the Fed begins addressing the timing and path of rate hikes. However, these results suggest that once the market digests the Fed s plans, forward guidance may help smooth further market volatility since expected rate hikes tend to only impact markets over short time horizons. On the other hand, when markets are caught off guard by rate hikes, they have longer-lasting impacts. Thus, by minimizing surprises and allowing the markets to gradually adjust expectations, successful forward guidance should reduce the effects of rate hikes on stock returns and volatility. Figure 6: Average Equity Market Sensitivity to Target Rate Increases Surprise and expected +25bps fed funds rate increases, (0.83) (0.67) (0.43) (0.14) -1.5 (1.48) Week 1 Month 3 Month 1 Week 1 Month 3 Month Sources: Standard & Poor s, Federal Reserve, J.P. Morgan Asset Management. For illustrative purposes only. Surprise and expected components are estimated from the Federal Funds Rate futures market. ** Coefficients are statically significant at a 1% level. *Coefficients are statistically significant at a 5% level. Data are as of 7/29/14. 4

5 Investment Implications While rate hikes can be negative for equities over short time horizons, steady rate increases have historically been positive over months and quarters. This is primarily because rate increases resulting from improving economic growth are correlated with positive stock returns in the long run. Rate hikes that are data dependent and forward guidance that is credible reinforce this trend. Additionally, a higher federal funds rate should translate into higher longer-term interest rates as well. While the details of this relationship are beyond the scope of this bulletin, Figure 7 shows that higher 10-year Treasury rates are positively correlated with stock returns when the level of interest rates is below 5%. This is because low but rising interest rates are a result of improving economic growth rather than inflation. Consequently, given the current level of interest rates and the evidence above, we believe that investors should continue to be positioned with an overweight to U.S. equities. Figure 7: Correlations Between Weekly Stock Returns and Interest Rate Movements Weekly S&P 500 returns, 10-year Treasury yield, rolling 2-year correlation, May 1963 July When yields are below 5%, rising rates are generally associated with rising stock prices Graph Key Last 12 Months Months Ago % 2% 4% 6% 8% 10% 12% 14% 16% 10-Year Treasury Yield Sources: Standard & Poor s, U.S. Treasury, J.P. Morgan Asset Management. Returns are based on price index only and do not include dividends. Markers represent monthly 2-year correlations only. For illustrative purposes only. Data are as of 7/29/14. 5

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