With the Federal Reserve now indicating that they are “really serious” about raising interest rates, there have come numerous articles and analysis discussing the impact on asset prices. To wit:
“‘Stocks typically sell-off on the first of a series of rate hikes, but the magnitude and duration of the sell-off depend on conditions,’ Bianco writes. ‘During early cycle hikes the initial sell-off was generally small, quickly recovered and further S&P gains came in next three months and longer (like 2004, 1983, 1972). But many sell-offs on late cycle hikes became corrections or even bear markets.’
Unfortunately, it’s only in hindsight do we know where we are in the cycle.
While David is correct in his analysis, in my view, it is too short of a window for investors. While the markets, due to momentum, may ignore the effect of “monetary tightening” in the short-term, what about longer-term?Â
That is the question I want to examine today. As shown in the table below, the bulk of losses in markets are tied to economic recessions. However, there are also other events such as the Crash of 1987, the Asian Contagion, Long-Term Capital Management, and others that led to sharp corrections in the market as well.
The next table shows the date of the first Fed rate hike, the corresponding level of GDP at the time of the first rate hike and the financial markets. It also counts the number of months until the next event which was either a recession, a market correction or both.
The point is that in the short-term the economy and the markets (due to the current momentum) can SEEM TO DEFY the laws of gravity as interest rates begin to rise. However, as rates continue to rise they ultimately acts as a “brake” on economic activity. Think about the all of the areas that are NEGATIVELY impacted by rising interest rates:
1) Rising interest rates raise the debt servicing requirements which reduces future productive investment.Â
2) Rising interest rates will immediately slow the housing market taking that small contribution to the economy away. People buy payments, not houses, and rising rates mean higher payments. (Read “Economists Stunned By Housing Fade” for more discussion)
3) An increase in interest rates means higher borrowing costs which leads to lower profit margins for corporations. This will negatively impact corporate earnings and the financial markets.
4) One of the main arguments of stock bulls over the last 5-years has been thestocks are cheap based on low interest rates. When rates rise the market becomes overvalued very quickly.
5) The massive derivatives and credit markets will be negatively impacted. Much of the recovery to date has been based on suppressing interest rates to spur growth.
6) As rates increase so does the variable rate interest payments on credit cards. With the consumer being impacted by stagnant wages and increased taxes, higher credit payments will lead to a rapid contraction in income and rising defaults.
7) Rising defaults on debt service will negatively impact banks which are still not adequately capitalized and still burdened by large levels of bad debts.
8) Many corporate share buyback plans and dividend issuances have been done through the use of cheap debt, which has led to increases corporate balance sheet leverage. This will end.
9) Corporate capital expenditures are dependent on borrowing costs. Higher borrowing costs leads to lower capex.
10) The deficit/GDP ratio will begin to soar as borrowing costs rise sharply. The many forecasts for lower future deficits will crumble as new forecasts begin to propel higher.
