24 Dec

Fed Rate Liftoff: Not Much Is Likely to Change

WRITTEN BY Rick Rieder

While everyone focuses on the Fed, this important topic isn’t receiving as much attention as it deserves. Rick Rieder explains, with the help of three charts.

With the December Federal Reserve (or Fed) meeting in the rear view mirror, discussions and speculation about the Fed liftoff have taken center stage.

But while I’ve certainly weighed in on this debate many times, I believe it’s just one example of a topic that receives far too much attention from investors and market watchers alike.

The Fed has been abundantly clear that the rate hiking cycle, that began this month, will be incredibly gradual and sensitive to how economic data evolves, meaning the central bank is likely to be extraordinarily cautious about derailing the recovery and rates will likely remain historically low for an extended period of time. In other words, even though the Fed has begun rate normalization, not much is likely to change.

Market Realist – The much-anticipated Fed rate liftoff happened last week. Now that the Fed has abandoned its zero interest rate policy, the focus has already shifted to ramifications for the markets and the theme of global central bank divergence. While most central banks—like the European Central Bank and the Bank of Japan—remain in easing mode, the United States has already embarked on a tightening cycle. And the United Kingdom (EWU) expected to follow suit. This could mean continued strength for the US dollar (UUP) and rising volatility (VXX) in the global markets.

So now that the Fed rate liftoff has finally arrived, should you flee to market sidelines? If you can believe history, the answer is an emphatic no.

Fed Rate Liftoff: Not Much Is Likely to Change

The graph above from BlackRock shows the three-month, six-month, and 12-month returns from the S&P 500 (SPY) during past Fed tightening cycles. The markets tend to react negatively to a rate hike in the short term, as evidenced by the negative returns in the three-month periods above. Though the S&P 500 posted negative returns over a three-month period, it grew by averages of 3.6% and 4.1%, respectively, over six-month and 12-month periods.

Fed Rate Liftoff: Not Much Is Likely to Change

The graph above shows the returns from the S&P 500 (IVV) subsequent to a rate hike from 1955 to the present. The S&P 500 (VOO) posted positive, albeit sub-par, returns of 1.4%, 3%, and 5.1% over the three months, six months, and 12 months following the rate hike. This shows that a Fed rate liftoff doesn’t necessarily create a bear market—or even a down market. You could expect a moderate correction near-term, but a major slump over the long term seems unlikely, given the historical data. Moreover, a moderate correction could actually be a good thing, given the rich valuations the markets currently sport.

Fed Rate Liftoff: Not Much Is Likely to Change

Plus, the Fed has clearly indicated that tightening will be gradual. The graph above shows the differences in the Fed’s September dot plot and the one released in December. Each dot represents a FOMC member’s opinion regarding the appropriate level of the federal funds rate. The new dot plot is largely similar to the one from September. The median estimates continue to range between 1.25% and 1.5% for the end of 2016, and ~3.5% in the long run. This suggests that the pace of normalization is likely to be gradual going into the next year, so Fed-driven market downturns may be unlikely.

We believe now may be the time to shift focus from the Fed’s rate hike timeline to some broad macroeconomic trends that are currently at play in the US economy. Read on to the next part of this series to learn more.

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