What does Fed Rate Hike Imply for stocks moving forward?

Below is a post written by Rivanna’s 2016-17 CIO Dan Pollick for Rivanna’s Spring’16 Newsletter about how stocks could be expected to react to an interest rate hike. This post is followed by a link to a Jim Cramer monologue discussing the Fed’s rate hike.

Rivanna Investments Spring 2016 Newsletter (Forward Guidance Section)

The path forward in the S&P500 for the remainder of 2016 will hinge on the Federal Reserve’s interest rate policy and the direction of the S&P500’s aggregate earnings.

Core inflation has remained persistently below the Fed’s target of 2%.[1] Because nominal GDP––the standard measure of economic performance––is a measure of “real” economic growth plus inflation, an inflation measure that is persistently too low feeds through to reduced nominal GDP growth, which in turn translates into lower wage/salary growth for consumers, and lower consumer-spending. Reduced consumer spending impacts US businesses and reduces incentives for business to make corporate expenditures. In short, a temporary and slight rise in core inflation closer to the Fed’s 2% target would be constructive for stocks in the near-term. However, because higher inflation is perceived as having the effect of pull-forward inevitable rate hikes, which all else equal tend to “slow” the economy. The prospect of higher rates, sooner in time––resulting in an otherwise slower economy––is perceived as detrimental to corporate profits.

Indeed, the last two “tightening” measures (e.g., policy actions designed to raise interest rates to normalized levels based on historical economic cycles) from the Fed––ending QE3 in December of 2014 and raising the Fed policy rate in December 2015––have been met with dramatic declines in the yield on the 10-year treasury bond in the subsequent 6-8 weeks following the move. In 2014, the yield fell from 2.34%––on 10/29/14, the date the Fed officially ended QE3–– to 1.68% on 1/30/15, where rates troughed. In 2015, the yield fell from 2.30%––on 12/17/15, the date the Fed raised its policy rate by 25 bps––to 1.63% on 2/11/16, where rates have most recently troughed.[2] These periods produced corresponding “mini-corrections” in the S&P500, most notably in January of 2016, which was the worst performing January in US stock market history.[3]

The read through from long-term interest rates collapsing in response to short-term interest rate increases (which is opposite of what is “supposed” to happen) is that the market views these tightening measures as lowering inflation expectations moving forward, which lowers the nominal GDP-outlook and the trajectory of future S&P500 profit growth. Nevertheless, the market accepts that the Fed will have to tighten, at some point, from the extraordinary low interest rates still in place as part of the Fed’s response to the financial crises of 2007-08. Thus, the stock market has been stuck in this catch-22 since the beginning of 2015: strong economic indicators are viewed as increasing the possibility of a near-term rate rise, which reduces the profit growth outlook for stocks as well as the multiple on which investors value those profits. However, in reaction to imminent rate increases, the economic variable that is presently of most concern to the Fed, inflation and inflation expectations, weakens. The Fed is then forced to delay increasing rates, which is bullish for stocks and constructive for inflation expectations (which is also bullish for stocks). The reaction in treasury yields (described above) to short-term tightening is illustrative this narrative.  It is also confirmed by a flat S&P500 over the last fifteen months (Jan’15–Present)––on 1/2/15 the index closed at 2058––compared to its close on 4/6/16 at 2066––combined with an upwardly sloped VIX-moving average over the same period. [4]

The upshot for stocks for the rest of 2016 is counter to conventional wisdom on the relationship between interest rates and stocks. A sustained move higher for the S&P500 will require an orderly and gradual rise in the 10-year treasury yield in response inevitable rate hikes that will occur over the next nine months, irrespective of how many the Fed enacts. A knee-jerk “mini-correction” (5-10%) in response to increases should be expected, given this pattern over the recent past. However, if the 10-year treasury yield sees an orderly move higher in response to higher short-term interest rates (maintaining a positive slope in the yield curve), stocks should respond by quickly retracing any losses, and then continue to move higher. Conversely, if the 10-year treasury yield declines in response to rate increase, as it did at the end of 2014 and 2015, stocks should be expected to decline until they are “cheap” on a valuation basis. In this macro-economic scenario, moreover, any subsequent rallies will likely fade once the market has recouped its most recent declines. Revenue and profit growth would also continue to be a headwind for stocks.

On the other hand, a sustained and gradual move higher in long-term treasury yields could be a tailwind for revenue and earnings growth by counterbalancing the effect of a stronger US-dollar relative other major currencies. All else equal, higher US rates would put upward pressure on the dollar. But higher trending interest rates across the yield curve would reduce the attractiveness of US-dollar denominated assets to intermediate and short term investors, who might risk losing principal if they wanted to exit these assets prior to maturity. This is significant because the rise of the dollar has been a significant headwind to US company profit growth since the beginning of 2015.

[1] “The Outlook, Uncertainty, and Monetary Policy” Federal Reserve Chairwoman, Janet Yellen, giving speech at the Economic Club of New York on March 29, 2016. (Hereinafter ‘Yellen NY Economic Club Speech’). Available at <https://www.federalreserve.gov/newsevents/speech/yellen20160329a.htm>

[2] Board of Governors of the Federal Reserve System (US), 10-Year Treasury Constant Maturity Rate [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/DGS10, April 10, 2016. S&P Dow Jones Indices LLC, S&P 500© [SP500], retrieved from FRED, Federal Reserve Bank of St. Louis https://research.stlouisfed.org/fred2/series/SP500, April 10, 2016.

[3]www.stlouisfed.org

[4] www.stlouisfed.org

 

Jim Cramer Reflection on Significance of Federal Reserve Rate Hike