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Sound Advice: November 9, 2022

The paradox of changing interest rates

With rare exception, the predominant belief is that when interest rates are rising, the stock market will slide . . . and vice-versa.  As recently as the early part of 2020, when the pandemic led to a widespread plunge in the economy, the Fed slashed interest rates and stocks did an abrupt about-face following a distressing drop and ended up the year with a well above average gain.  A silver bullet, indeed.  But the reality is that over extended periods, there’s more than sufficient evidence to show that the market’s reactions to the Fed’s efforts to stimulate or ease the pace of the economy vary widely.

At the moment, we are faced with an inflation rate in the high single digits and, despite the central bank’s recent series of unusually high hikes in the federal funds rate, one suspects that even more tightening will be needed to get an unacceptably high rate of price increases under control.  Over the last 50 years, when the Fed did approve a change, it was almost always in the range of 0.25% to 0.50%, the latter viewed as rather hefty.  Yet, in all three of their latest three meetings, the governors voted for increases of 0.75%.  And there may well be more of these to come.

Given the stock market’s extended pullback so far this year, one has to wonder whether there may be more big dips ahead.  A look at what happened during each of the last five periods of rising rates (a span from February, 1994 to July, 2019) suggests a less pessimistic picture.  The average market change, as measured by the Dow Jones Industrial Average, while rates were climbing was a gain of 62.9%.  One of the more interesting examples was the time from June 29, 2004 to September 17, 2007 when the federal funds rate skyrocketed from 1.0% to 5.25% . . . and the Dow gained 28.7%.

Yes, this time is different.  Rates have been going up much more rapidly than ever before.  Even so, there will come a point when the impact of tighter monetary policy starts to produce the hoped-for results.  The risk is that, as has often been the case in the past, the economy will be hit too hard.  That will lead to a subsequent easing.

Once the prospect of rate easing emerges, stocks will rebound and bonds, which have been hit by rising interest rates, will also be positioned to provide both a reasonable current yield and price appreciation. 

We are not there yet, but could be within a matter of months.       

N. Russell Wayne, CFPÒ

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