The Impact of Rising Rates on Markets
A lower interest rate doesn’t make a debt go away.
After supporting the American economy by buying bonds since the COVID-19 pandemic in March 2020, the Federal Reserve is finally slowing down its purchases with the intent to end its bond buying program sometime in 2022. GYC wrote about the possible “taper tantrum” in July this year making the case that markets would remain mostly unaffected given the changed world dynamics and the health of the economy compared to 2013.
However, some concerns may have arisen due to the financial media’s penchant for reporting a slightly more dramatic outcome:
Straits Times
S'pore interest rates may remain low for now, but era of cheap money is about to endYahoo Finance
Investor: Fed taper, inflation ‘the worst equation’ for the market, sees 15% correctionMarketWatch
Hedge funds seen facing heavy losses amid wrong-way Treasury bets ahead of Fed tapering, traders sayReuters
Wall Street banks step up preparations for Fed tapering volatilityWSJ
Bill Ackman says the ‘Fed should taper immediately and begin raising rates as soon as possible’
We can’t dispute that rising costs and inflation are at our doorstep. You may have noticed that the prices of a lot of your favourite goods have ticked up, some significantly, over the past few months. Speculation in some areas of investments is also running wild. Cryptocurrencies have hit new records and house prices in Singapore have literally hit the roof (pun intended).
We could however, argue against the claim that a doomsday outcome on stocks is certain whenever interest rates rise, a claim that Bill Ackman and the other analysts seem incredibly sure of. A look at an extremely long-term market outcome and rising yields (using the S&P 500 as a proxy) shows that stock markets do just fine when interest rates rise (shown in the table below). Out of 14 rising rate environments, markets ended up negative in only 2 instances — first, a result of the collapse of the Bretton Woods fixed exchange rate system in the 70s and second, the energy crisis in early 80s.
Another seemingly plausible claim would be that bonds as an asset class would be greatly affected by changes in interest rates. After all, one of the most commonly understood relationships in finance is that bonds have an inverse relationship to interest rates — when rates rise, bond prices usually fall and vice versa. The diagram below shows the range of returns of the various bond asset classes and global equity in the previous rate hike cycles. As the variation and volatility can be quite wide, the key lesson is to ensure that your assets are diversified and of high quality, with the ability to buffer external shocks.
To show that the relationship is not always linear, research and data from Dimensional Fund Advisors shows that changes in the Fed Funds effective rate does not necessarily equate to a loss in bonds (shaded area).
All in all, you need not fear a rising rate environment. Neither do you need to predict what the central banks of the world are going to do next. While rising rates may mean that you should probably keep an eye on any existing mortgages (which would directly be affected by rate hikes), your investments — as long as they are properly constructed — will continue chugging along towards your goals.
There is absolutely no need to tweak anything in your portfolio; as the charts above show — there is no clear direction where markets will head to when rates rise. Nevertheless, if you are feeling concerned about what could happen to your investments, get in touch with us for a second opinion.
