We have witnessed benign inflation and interest rates globally for the past several years. However, the US federal funds rate could begin to take flight in late-2015 as growth continues at a moderate pace in the United States. An upward trending interest rate cycle is generally bullish for equities (see Figure 1) and bearish for fixed income. However, the transition to rising Federal Funds rates can be confusing for capital markets.
Figure 1: S&P 500 and US Fed Funds Rate (Monthly)
As a result, we have taken a closer look at the initial stages of the 2004 rate hike cycle and its potential implications for the stock market in the coming months. Referring to Figure 2, we highlight key monetary events in 2004 and illustrate the impact on the S&P 500:
A: Jan 28/04: Fed leaves bank lending rate at 1%, but removes the “considerable period” (of monetary accommodation) phrase from its statement and signals that rates could rise in the “late spring, early summer.” The S&P 500 makes three attempts at new highs before declining 5-6% in March 2004. B: Apr 23/04: Fed Governor Ben Bernanke said that monetary policy is “in a transition phase” and “short-term interest rates must eventually normalize.” The S&P 500 retests its 2004 lows after attempting to regain its highs. C: Jun 30/04: Fed raises the bank lending rate to 1.25% (from 1%). The S&P 500 makes a new low by early August 2004, dropping 8% from its 2004 high.
Figure 2: S&P 500
In conclusion, the transition period to tighter monetary policy resulted in sideways-to-downward trending equities in the short-term. Will the coming interest rate hike hold a similar fate for US equity markets? The one key ingredient that makes the coming rate hike cycle different is the $4.4 trillion in asset purchases from quantitative easing (QE) that currently sits on the US Federal Reserve balance sheet, compared to just $800 million in 2004. This massive balance sheet might actually make it easier for the Fed to manage interest rates as it attempts to (very) gradually reduce liquidity in a US economy that is still relatively fragile from a long-term perspective.
Hence, the Fed and capital markets are truly in uncharted territory as its attempts to lift the US Federal Funds rate off of the floor. The piece of the puzzle that does appear to be clear is the fact that despite the short-term noise and 5-10% equity correction that was characteristic of 2004, equities resumed their upward trajectory shortly after rates achieved lift-off.