Analyzing The Impact Of Fed Rate Hikes On Markets & Economy

There has been much discussion as of late about the end of the current quantitative easing program and the beginning of the Federal Reserve "normalizing" interest rates. The primary assumption is that as interest rates normalize, the financial markets will continue to rise as economic growth strengthens. While this certainly seems like a logical assumption, is it really the case?

As I discussed in "The Great American Economic Growth Myth:"

"From 1950-1980 nominal GDP grew at an annualized rate of 7.55%. This was accomplished with a total credit market debt to GDP ratio of less 150%. The CRITICAL factor to note is that economic growth was trending higher during this span going from roughly 5% to a peak of nearly 15%. There was a couple of reasons for this. First, lower levels of debt allowed for personal savings to remain robust which fueled productive investment in the economy. Secondly, the economy was focused primarily in production and manufacturing which has a high multiplier effect on the economy. This feat of growth also occurred in the face of steadily rising interest rates which peaked with economic expansion in 1980."

This is clearly shown to be the case in the chart below.

It is important to note in the chart above that each time the business/economic cycle slowed, interest rates never fell to a level lower than they were previously. As economic growth, while bumpy, trended higher over time; so did interest rates.

As I wrote previously, that all changed.

"However, beginning in 1980 the shift of the economic makeup from a manufacturing and production based economy to a service and finance economy, where there is a low economic multiplier, is partially responsible for this transformation. The decline in economic output was further exacerbated by increased productivity through technological advances and outsourcing of manufacturing which plagued the economy with steadily decreasing wages. Unlike the steadily growing economic environment prior to 1980; the post-1980 economy has experienced by a steady decline. Therefore, a statement that the economy has had an average growth of X% since 1980 is grossly misleading. The trend of the growth is far more important, and telling, than the average growth rate over time."

Notice that since 1980, interest rates have been in a steadily declining trend.  Each increase in interest rates failed to attain a level higher than the previous peak, and each low was lower than before.

Currently, both "market bulls" and economists are ignoring the historical impact of inducing higher borrowing costs on the economy. The chart below shows the 3-month average of the effective Fed Funds rate. I have highlighted (vertical blue dashed lines) when the Fed Funds rate bottomed after a decline and turned up.

As you will notice, the effective Fed Funds rate fell sharply heading into and following recessionary periods in the economy. This is really not surprising given the fact that the Federal Reserve adjusts interest rate policy in an attempt to control the economic cycle. Unfortunately, there is no evidence that they have ever been successful in doing so.

The next chart shows the impact of rising Fed Funds versus the S&P 500. Once again I notated (vertical blue dashed lines) when rising interest rates coincided with a peak in the financial markets.

 

It should really come as no surprise that rising interest rates, Fed Funds or otherwise, eventually has a negative impact on the financial markets. As interest rates rise, so does the costs of operations which eventually leads to a decline in corporate profitability. As corporate profitability is reduced by higher borrowing costs, market excesses in price are eventually unwound.

As I wrote in "Why Market Bulls Should Hope Rates Don't Rise:"

"The problem with most of the forecasts for the end of the bond bubble is the assumption that we are only talking about the isolated case of a shifting of asset classes between stocks and bonds.  However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices has very little to do with the average American and their participation in the domestic economy. Interest rates, however, are an entirely different matter."

The table below shows the history of Federal Reserve rate hikes, from the month of the first increase in the 3-month average of the effective Fed Funds rate to the onset of either a recession, market correction or both.

From this data, we can make some assumptions about the current bull market cycle if we assume that the Federal Reserve will begin hiking interest rates at the beginning of 2015.

The average number of months between the first rate hike and a recession has been 42.4 with a median of 35 months. However, if we take out the two extremely long periods of 98 months following the 1961 increase and 84 months following 1994; the average falls to just 28.6 months.  Given the fact that the current economic cycle is extremely weak and, at more than 60 months, already the fifth longest Post-WWII recovery, it is likely that even 28 months is on the long end.

The average stock market correction following the first rate has occurred 21.2 months later. If the first rate hike occurs in 2015, this would put the next market correction in 2016 which would correspond with my recent analysis on the collision of the "Decennial and Presidential Cycles:"

"The statistical data suggests that the next economic recession will likely begin in 2016 with a negative market shock occurring late that year, or in 2017. This would also correspond with the historical precedent of when recessions tend to begin during the decennial cycle.  As shown in the chart below the 3rd, 7th and 10th years of the cycle have the highest occurrence of recession starts."

Most importantly, the number of times that Federal Reserve has hiked interest rates without a negative economic or market impact has been exactly ZERO.

There are two important points to take away from this analysis.  First, as I discussed previously, there is an ongoing belief that the current financial market trends will continue to head only higher. This is a dangerous concept that is only seen near peaks of cyclical bull market cycles. While the analysis above suggests that the current bull market could certainly last some time longer, it is important to remember that it is "only like this, until it is like that."

The problem for most investors is that by they time they recognize the change in the underlying dynamics, it will be too late to be proactive.  This is where the real damage occurs as emotionally driven, reactive, behaviors dominate logical investment processes.  

The second point is far more important when performing analysis such as this:

"Past performance is no guarantee of future results."