Interest Rates Matter, But They Don’t

It’s been hard to pick up a newspaper or watch the news lately without hearing about the Federal Reserve (the “Fed”) and interest rates. The implication is that what the Fed does has a big impact on the economy and investments, and that is correct. However, it is also implied that we can predict what the impact will be (many are doing so right now) and that we can manage our investments to take advantage of a change. This is largely wrong.

The long-term economic impact of raising or lowering interest rates is an unknown. The Fed seeks to keep the economy growing and stable. That means avoiding or shortening a recession, but also not allowing the economy to “overheat” as this would lead to an eventual crash. When the Fed moves interest rates higher or lower they are simply trying to find the middle ground between a recession and an overheating economy. It’s akin to adjusting the heat on a stove so that the water boils but doesn’t boil over. But the economy is much more complex and the opportunity for error much greater. Therefore, many pundits jump into the conversation and insist that their view is correct. These pundits have all of the same information as the Fed and have no greater skills, they should be ignored.

The second, and more relevant, point is that investments can be managed in anticipation of a change in interest rates. It’s true that some investments will move more than others as interests rates rise. For example, bond prices generally fall when rates rise to reflect the fact that investors can now earn a higher return. The problem is in timing the Fed. For example, in 2014 most pundits predicted that interest rates would rise and many sold bonds in anticipation. Interest rates fell in 2014 and bonds returned a reasonable 6%.

Interest rates can also affect stock prices, but timing is also a problem with stocks. It’s not only important to predict when the Fed will start raising rates, but you must also predict when the rate rise will begin to impact markets. The table below shows the impact of the last 15 rate rises by the Fed. On average, the market went up 4.4% in the 12 months after the start of rising interest rates. The average is skewed by a huge jump during the dot com bubble. But the 12-month increase was still 3.1% when this, and the worst, period are not included. This compares to an average annual return of 6.7% during the entire period considered.

 

Period of Rising Rates 12-Month Change in S&P 500
December 1965 – December 1966 -12%
August 1967 – September 1969 3%
April 1971 – September 1971 7%
March 1972 – October 1973 5%
March 1974 – September 1974 -15%
February 1977 – May 1980 -13%
August 1980 – July 1981 8%
January 1982 – March 1982 15%
March 1983 – September 1984 6%
February 1987 – November 1987 -6%
April 1988 – April 1989 14%
February 1994 – March 1995 -2%
April 1997 – May 1997 46%
July 1999 – July 2000 6%
June 2004 – August 2006 6%
Average 4.4%
Average without best & worst 3.1%
Source: Deutsche Bank via Business Insider

In general, stocks do better when interest rates are not rising, but rising rates haven’t been a disaster for stocks. Predicting when rates will rise, and how prices will be impacted, is a fools game. Ignore the chatter over the Fed and interest rates. Instead, focus on maintaining a reasonable and consistent asset allocation, and finding good investments within that allocation.