Investors comparing December's rate hike to previous ones will make a grave mistake

By Charles Younes FE Research and Opinions

Updated on Wednesday, 13 January, 2016

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Investors looking for a way in to the markets following the Federal Reserve rate hike are too late, according to the latest FE Research report, because the market had already reacted to the rate hike back in May 2013.

Research manager at FE, Charles Younes says: “Investors will make a grave mistake if they try to compare previous rate hikes to the one this month, as this rate hike and reactions in the market to it has already happened back in May 2013.

“What that means is, in May 13 there was the taper tantrum where the market reacted just as if it would have done had there been the first interest rate hike in the rate cycle.”

Typically, equity markets tend to react negatively in the months following an interest rate hike and only pick up after 6 months to a year. It takes time before investors realise that the economic environment can actually keep up with tightening monetary conditions.

Equities tend to do well prior to an interest rate hike as the economic environment is more favourable to the asset class, whilst central banks will hike rates when they judge that economic conditions are strong enough or if there are higher inflationary pressures on economies

The report notes:

Part I - Equities

  • Equities react badly to an interest rate over the short term. Performance is negative in the three months after the interest rate rise. Nevertheless performance turned positive in the next six months and one year.

*There is one exception where a rate hike saw a longer recovery period for equities, and that was in 1994: Investors were surprised by the Fed decision and equities performed badly after the announcement, even after one year. It looks like the Fed’s 1994 decision cut the economic growth – so share prices reacted badly. In 1999 and 2004 the Fed simply adjusted the pace of the economic growth – which was welcomed by equity investors.

Part II - Fixed Income

  • For fixed income securities, performance depends on the market anticipation for a rate increase. In 1999 and 2004, fixed income investors expected the Fed to increase its base rate. As a result the market had already priced this event in, with all fixed income securities performing badly.

*Due to being less sensitive to interest rates, high yield instruments fared better than investment grade corporate bonds, Treasuries and Inflation-linked treasuries. The interest rate increase was seen as a relief and all fixed income instruments did well after the much-expected announcement.

In 1994 and May 2013, investors were not expecting the Fed to tighten the monetary base. This event was not priced in by fixed income investors. As a result all fixed income instruments had a negative performance after the announcement. Even high yield instruments did badly after this unexpected announcement. See graphs below.

Part III: December 2015 is not the first interest rate hike

  • Both equity and fixed income markets had been behaving very differently to previous interest rate hike situations. Equities did badly before the announcement. High Yield underperformed strongly. It looks like the true first interest rate increase occurred in May 2013 with the tampering tantrum. As a result, the interest rate increase in December 2015 can be viewed as a second step in the normalising cycle. The first interest rate rise occurred in May 2013. See graphs below

Younes adds: “And as is often the case in the markets, the past is not a guide to future returns. In the past, the Fed’s decision to increase interest rates was triggered by inflationary pressures.

“This time, with the oil price dropping below $40, there is no such pressure. We should also point out the Chinese slowdown and the weight of the Chinese economy now on our global economy and the effects that has been having on markets.”

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Source: All images constructed from FE Analytics data