53.8 F
Laguna Hills
Tuesday, Mar 19, 2024
-Advertisement-

OC LEADER BOARD

Last month’s decision to increase the federal funds rate by 25 basis points was probably the most widely anticipated announcement in the history of the Federal Reserve Board.

The intense media attention was likely due to the fact that it’s been almost nine years since the Fed began reducing the rate from a peak of 5.25% in the third quarter of 2006. That started the longest period the Fed has allowed the rate to be on a downward trajectory since 1950. The next closest was the four-year decline between 1989 and 1993, when the fed funds rate was lowered from 9% to 3%.

The Fed’s move to begin increasing the rate comes with concern in financial markets about the effect on stock markets. Many have argued that the near-zero short-term interest rate policy the Fed has followed has led investors to seek higher returns in equity investments, thereby leading to a stock market bubble. A rise in short-term rates, the argument goes, might burst that bubble.

Sharp declines in stock markets in early 2016 seem to support such an argument.

Yet one can better evaluate the risk of the onset of a bear market with a look at what happened to equity prices in previous periods when the Fed started ratcheting up rates.

The following table shows that this has happened 12 times since the 1950s.

It’s notable that the S&P 500 average increased from the beginning to the end of 11 of the 12 periods the Fed pushed up rates. The lone exception was the increase that occurred during the two years from the third quarter of 1967 (1967:3 on chart) to the same period in 1969 (1969:3), a period that saw the rate increase from 3.9 to 9.9%. The decline was scant even during that period, however, with the S&P 500 off by just 1.6%.

One might argue that the next round of rate hikes is different from previous periods of rate increases, since the current rate is near zero. In 1958:2, however, the fed funds rate was close to zero at 0.9% before increasing to 4% by 1959:4. The S&P 500 increased 32.3% during the period, significantly higher than any of the other 11 periods of rising rates.

The most recent cycle of increase—2004:2 to 2006:3—started with the rate at just 1%. The Fed pushed that rate to 5.3% in a little more than two years—a period that saw the S&P rise 14.7%.

The empirical findings that rising fed funds rates are almost always associated with increasing stock prices should not be surprising. The Fed typically pushes up rates to cool an economy perceived to be overheating, with higher consumer spending typically the key indicator on the body’s radar. Higher levels of consumer spending lead to higher corporate earnings. That explains why the S&P average earnings per share increased during all 12 periods of Fed tightening. Those increases in earnings per share in turn placed upward pressure on stock prices.

A final point: The S&P 500 advanced to the end of the relevant cycle in the most recent four instances of Fed interest rate increases. It also advanced through the end of the 1977:1 to 1980:1 cycle.

The other seven cycles saw the S&P 500 decline during the final quarters of the cycle, with a lead of one to four quarters. The index nevertheless was higher at the end of 11 of the 12 cycles on a start-to-finish basis.

These findings, of course, don’t assure us that the upcoming round of rate increases will be associated with higher stock prices. But they certainly don’t suggest that they won’t. Quite the contrary.

 

Want more from the best local business newspaper in the country?

Sign-up for our FREE Daily eNews update to get the latest Orange County news delivered right to your inbox!

-Advertisement-

Featured Articles

-Advertisement-
-Advertisement-
-Advertisement-
-Advertisement-

Related Articles

-Advertisement-
-Advertisement-