Four Fed presidents gave speeches yesterday, and every word was digested by the stock market in an attempt to better predict the Fed’s next move. With odds of a December rate hike now about even, how should stock investors prepare?
Not raising rates is usually seen as the better choice for the stock market today. After the Fed’s latest meeting ended last week, the central bank kept rates steady once again, and the stock market surged. The S&P rose 1.75% after the announcement, and the Nasdaq hit a new high.
For an example of the opposite scenario, we can look at what happened when the Fed did raise rates last year. After many months of anticipation, the Fed finally announced a quarter-of-a-percent hike in December 2015, seen on the last panel of the chart below.
The middle panel of the chart shows the S&P 500 (represented by the SPDR, SPY). The index dropped in the two days immediately following the hike, before rebounding for about a week. However, this year’s January-February correction quickly followed—though it was generally blamed on low oil prices and global economic uncertainty. And of course, the stock market today is close to new heights and has recovered quite nicely over the last seven or eight months.
Of course, not all stocks react to interest rate hikes in the same way. Financial firms tend to prefer higher rates—because they can lend and invest more profitably—so you’d expect financial stocks to reflect this by going up when rates are going up. They’ve been treading water since the last rate hike though, in part because the increase in the Fed Funds rate was actually followed by a decline in long-term rates. You can see the yield on the 10-year Treasury steadily falling since the rate hike in the top panel of the chart above.
While financials are supposed to be positively correlated to interest rates, other sectors are generally accepted to have the opposite relationship. Utilities (represented by the Utilities SPDR, XLU) and dividend paying stocks both become less popular when rates are higher, because fixed income investments—which have similar characteristics—become more attractive.
The graphic below from the Wall Street Journal shows the relationship between the 10-year Treasury yield and an index of Dividend Aristocrats year to date. The periods when the Treasury yield was falling have been some of the best for dividend stocks.
(In addition to the “substitution effect,” Dividend Aristocrats and 10-years Treasuries are also both beneficiaries of what’s called the “flight to quality,” the tendency of investors to pile into conservative, low-risk, high-quality investments when fear levels are high.)
Of course, on an absolute basis, long-term interest rates remain in the basement, and that continues to drive interest in yield stocks. Since the Fed increased rates by 0.25% last December, utilities have been one of the strongest sectors of the stock market and the iShares Dividend Index (DVY) has advanced 14% vs. the S&P 500’s 5%.
Some of this is, again, due to the fact that long-term interest rates—which affect the rates utilities pay on their debt, and the viable alternatives to dividend stocks for income investors—are still at historical lows. Some of it can also be chalked up to classic “buy the rumor, sell the news” behavior.
For another example of the unpredictable relationship between rate hikes and stocks, take a look at what happened when the Fed hiked rates—numerous times—between 2004 and 2006.
The Federal Reserve started raising rates in May 2004 and over the next two years gradually increased the target Fed Funds rate from 1% to 5.25%. The last increase came in May 2006.
Contrary to expectations, during this two-year period, utilities (represented by XLU in the chart below) outperformed financials (XLF) by a large margin!
So even if the Fed does raise rates in December (and that’s still a pretty big “if”), there’s no reason for dividend investors—or any other equity investors—to panic. The way it affects the stock market today could be quite different from how it affected it more than a decade ago.
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