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Advisors - June 17, 2022

What Happens After A Fed Rate Hike?

Fasten your seatbelts, everyone—interest rates have lifted off.

In June 2022, the Fed Chair Jay Powell and the FOMC voted to hike their target range by 75 basis points, to 1.50-1.75%. Marking the largest single hike since 1994, the Fed delivered investors a mixed bag of emotions—everyone wants inflation to cool off, and a higher Fed Funds Rate should help, but the bear market for equities has already been painful enough. Back in March 2022, the Target Federal Funds Rate was raised from a range of 0.00-0.25% to 0.25-0.50%, marking the second time in history that the Fed has raised rates from 0%.

Chart of US Federal Funds Rate vs Inflation since 1954

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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 States serves several purposes ranging from promoting stability in the financial system to regulating financial institutions and their activities. One of the Fed’s major functions is 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 the Federal Open Market Committee (FOMC). The FOMC usually 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 outpacing the 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 the 1-Month, 3-Month, 6-Month and 1-Year T-bills. 

Longer-term treasuries, like the 10-Year Note and 30-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 because the 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).

Chart of how US Treasuries move with the Federal Funds Rate, since 1989

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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.

 

How Consumers Are Affected by Fed Rate Hikes

Prime Loan Rate

The Prime Loan Rate measures the rate at which banks lend to their most creditworthy clients. A rule of thumb for calculating the Prime Loan Rate is:

Target Fed Funds Rate + 3 points = Prime Loan Rate

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.

Chart of how the Prime Loan Rate moves with the Federal Funds Rate, since 1954

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Credit Card Interest

Changes to the Fed Funds Rate can also influence credit card interest rates, known to all of us as Annual Percentage Rate (APR). 

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.

Chart Credit Card APR Rate movement with the Fed Funds Rate since 1994

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Mortgage Rates

The prevailing 30-Year Mortgage Rate, and its 15-Year counterpart, tend to follow the 10-Year Treasury Rate more so than the Fed Funds Rate. Mortgages are backed by bonds and securities, which align more with an instrument like the 10-year treasury. The Fed doesn’t directly target long-term instruments, but since rates of most shapes and sizes experience a ripple effect from the Fed’s actions, mortgage rates tend to do the same.

Chart showing how Mortgage Rates move with the Federal Funds Rate, since 1971

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Savings Accounts & CDs

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 on savings 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.

Chart showing how rates for Certificates of Deposit and Savings Accounts move with the Federal Funds Rate

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How Stocks Are Affected by Fed Rate Hikes

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. The S&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.

Chart showing the S&P 500 in relation to the Federal Funds Rate, since 1981

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Comparing The Two Times Rates Were Raised from 0%

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 time around, the Fed has hiked rates more aggressively. Recent rate hikes include 50 basis points in May 2022, 75 basis points in June 2022, and talk of future rate hikes at 75 basis point increments are reportedly on the table.

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.

Chart comparing movements of the S&P 500, NASDAQ, and Dow Jones Industrial Average when the Fed raised rates in 2016 and 2022

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What Happened to Bonds When the Fed Funds Rate Was Raised from 0%?

As the Fed gradually raised rates starting in 2015, shorter-term treasury bills moved higher in tandem, while longer-term bonds rose marginally as well. As the Fed raises rates more rapidly in 2022, treasury yields of all shapes and sizes are shooting higher in response.

Chart comparing movements of the 10-Year and 30-Year Treasuries when the Fed raised rates in 2016 and 2022

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What Happened to Consumers When the Fed Funds Rates Was Raised from 0%?

The interest rates on prime loans, mortgages, and credit cards all rose with the Fed Funds Rate during the hikes of 2015 through 2018. As mentioned earlier, mortgage rates have more closely tracked the 10-Year Treasury Rate. Around the time the Fed stopped raising rates in 2018, mortgage rates actually fell. This was due in part to the Federal Reserve’s own concern over the possibility of slowing economic growth in 2019. With increasingly more talk of a recession among the American public, could mortgage rates repeat history and trend downward, opposite to the trajectory of the Fed Funds Rate?

Chart showing the movements in mortgage rates, credit card APR interest, and Prime Loan Rate when the Fed raised rates in 2016 and 2022

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The Bottom Line

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”.

 

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