Keep those seatbelts fastened, everyone—interest rates continue to ascend well above 10,000 feet.
In December 2022, Fed Chair Jay Powell and the FOMC voted to hike their target range by another 50 basis points, to 4.25-4.50%. Though a step down from four consecutive “jumbo” rate hikes of 75 basis points each seen earlier this year, the most recent Fed announcement delivered investors a mixed bag of emotions. US Inflation has come down from a more than 40-year high of 9.1%, but a side effect has been a vicious bear market that sent the S&P 500 down 25% this year at its lowest point. Fed officials also stated they expect no rate cuts to occur until 2024. TheTarget Federal Funds Rate went from 0% to its highest level in 15 years in a span of just nine months.
On the surface, the Fed Funds Rate may seem like just one interest rate out of the many that exist in our complex financial world. However, there’s an old investing mantra that goes“Don’t Fight the Fed”. Meaning, it would be wise to align your investment choices with the actions of the Fed.
With that in mind, how powerful are the Fed’s decisions regarding monetary policy? What kind of effects do those decisions cast, and how do certain markets and sectors of the economy react to changes in the Fed Funds Rate?
What is the Federal Reserve and the Fed Funds Rate?
The Federal Reserve was created in 1913 under President Woodrow Wilson through the Federal Reserve Act. Known as “the Fed” for short, the central bank of the United Statesserves several purposes ranging from promoting stability in the financial system to regulating financial institutions and their activities. One of the Fed’s major functionsis setting U.S. monetary policy in order to achieve its “dual mandate” set by Congress: maximum employment and long-term price stability (i.e. inflation) in the United States.
Monetary policy is set by a body within the Federal Reserve called theFederal Open Market Committee (FOMC). The FOMCusually meets eight times a year to review economic and financial conditions, and vote on changes to monetary policy. Policy is typically implemented via changes to the Fed Funds Rate, the benchmark rate at which financial institutions lend to each other.
If the FOMC deems that macroeconomic events warrant an increase to the Fed Funds Rate, such as inflation outpacingthe Fed’s long-term target of 2%, the committee would raise the Fed Funds Rate to prevent the economy from overheating. If the economy appears to be stalling out, the FOMC may attempt to spur economic growth by lowering its target rate.
Whether the FOMC votes to raise the Fed Funds Rate, lower it, or keep it unchanged, each decision produces winners and losers throughout the economy. So which assets are most impacted by changes to the Fed Funds Rate?
How Bonds Are Affected by Fed Rate Hikes
Short-term Treasury Bills, and the yields they can offer, are most directly affected by the Fed’s monetary policy,as stated by the Fed itself.
Though any fixed income instrument is subject to the ebbs and flows of the open market, short-term treasuries have historically moved in near lockstep with the Fed Funds Rate. This relationship is strongest for the1-Month,3-Month, 6-Month and1-Year T-bills.
Longer-term treasuries, like the10-Year Note and30-Year Bond, don’t typically follow the Fed Funds Rate as closely, though they have trended along its general direction over the last 30 years. This is becausethe Fed does not directly target long-term interest rates and the maturities on these instruments are denoted years or even decades out in time (meaning their purchase prices and yields are subject to greater and more numerous potential risks).
It’s important to note that bonds’ face values typically decline as rates go up. In a rising rate environment, new bonds offering higher interest payments will be issued, causing existing ones to fall in price.
The US Bank Prime Loan Rate is strongly correlated with the Fed Funds Rate and tends to move along with it, as seen in the chart below. Any further Fed rate hikes are quite likely to increase the amount Prime Loan Rate borrowers are charged.
The relationship between the Fed Funds Rate and credit card interest rates is relatively strong historically, but since 2003 the average APR has been less directly affected by rate changes. While credit card interest rates rose with the Fed Funds Rate starting in 2015, they lowered only slightly when the Fed cut rates to 0%, unlike previous low or zero-interest periods.
One group that stands to benefit from Fed Rate hikes are savers, or depositors.When banks compete for individuals’ deposits, they often incentivize potential customers by raising interest rates onsavings accounts and certificates of deposits (CDs). CD rates rose in response to Fed rate hikes in 2015 and through 2019, though they fell to extreme lows when the Fed Funds Rate went to zero in 2020. Nevertheless, the rates on savings accounts and CDs would be poised to receive bumps as the Fed Funds Rate is raised.
When the Fed raises rates, the cost of borrowing increases for businesses as well as individuals. Higher costs and cutbacks on capital expenditures could mean lower top and bottom lines for corporations, and thus reduced stock prices. Companies that rely on cheap access to capital, often growth-focused companies, may find it more difficult to finance expansion, and therefore become less able to justify their current valuations.
Stocks have thrived significantly in previous low-rate environments. In addition, the stock market started picking up steam as the Fed Funds Rate fell from its peak in 1981. TheS&P 500 has risen 8.3% on an annualized basis since then, but with the index entering bear market territory in 2022, investors will be watching to see how the ongoing rate hike cycle affects the market’s direction. Of note, equity investors may still welcome a Fed Rate hike if its meant to combat rising inflation, a strong headwind against stocks.
In December of 2015, the Fed began raising rates from the 0.00-0.25% target in light of sustained economic activity, a continued decline in unemployment, and expectations that inflation would rise to a 2% average. Three years later,the Fed stopped raising rates at a target range of 2.25-2.50% after inflation hovered around that 2% target for several months. The Fed gradually raised rates in 25 basis point increments through December 2018.
This cycle has seen the Fed raise rates more aggressively. Recent rate hikes include 50 basis points in December 2022, preceded by 75 basis point hikes in June, July, September and November. The Fed currently projects its “terminal rate” to be 5.1%.
Because the Fed Funds Rate has been set to zero only twice in history, 2022 also brought the second instance ever in which the Fed has raised rates from 0%. With all this in mind, how have different asset classes and indicators fared under the rate hike cycle of 2015-2018 compared to 2022?
What Happened to Stocks When the Fed Funds Rate Was Raised from 0%?
After the Federal Funds Rate effectively reached 0% at the end of 2008, US stock indexes entered a bull market that would last more than a decade. It was a largely uninterrupted bull market for the Dow Jones Industrial Average, S&P 500, and especially for the growth-heavy NASDAQ thanks in part to the “cheap money” provided by near-zero rates.
Around the time of the initial rate hikes in 2015, the indexes fell sharply on back-to-back occasions, but then continued to charge higher for a number of years during the Fed’s rate hike cycle. When rates reached 2% in 2018, there was a sizable correction late in the year. That correction also occurred just before the Fed ceased raising rates at 2.5%.
At the onset of the COVID-19 pandemic, when the Fed lowered its target range to 0.00-0.25% once again, the indexes switched back into bull market mode. Largely mirroring what happened at the end of 2008, the NASDAQ outpaced both the Dow and S&P 500 while rates were at 0%.
In 2022, the market started turning south just before the Fed began raising rates, partly because the Fed has become more vocal about their future plans. Though stark differences exist between the economic climates of the two rate hike cycles—inflation reaching over a 40-year high in 2022, among others— the Fed’s moves sent jitters through the markets in both cycles.
What Happened to Bonds When the Fed Funds Rate Was Raised from 0%?
As the Fed gradually raised rates starting in 2015, short-term treasury bills moved higher in tandem, while long-term bonds rose marginally as well. After the Fed rapidly raised rates in 2022, treasury yields of all shapes and sizes are shot higher in response.
The Fed is raising its benchmark Fed Funds Rate in an attempt to control inflation and stabilize prices in the US. Changes to this rate can cause a variety of effects throughout financial markets. Some areas of the economy tend to feel head-on impacts from the Fed Funds Rate, while others may experience lighter ripple effects. Whatever investments you own or are seeking to acquire, it pays to know the impacts of the Fed Funds Rate so you don’t find yourself “Fighting the Fed”.