Unmasking Wall Street’s Interest Rate Bogeyman

By MarketsFOXBusiness

Janet Yellen spooked Wall Street last week by saying the Federal Reserve may hike interest rates just six months after the central bank wraps up quantitative easing.

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The initially negative reaction by the market underlines fears among investors about how stocks will fare once interest rates bounce off their incredibly low levels. But could those jitters be misplaced given that rates will remain very low even after the Fed acts?

According to S&P Capital IQ, since 1977 the S&P 500 has posted average monthly price increases even as the yield on the 10-year Treasury note rises, at least up until the 6% “line in the sand” threshold.

“As a general rule, a rise in interest rates does not kill off a rally in equities,” said Peter Kenny, CEO of financial technology firm The Clearpool Group.

That’s in part because a Fed rate hike would be a positive development, signaling the U.S. economy is finally strong enough to ease away from unbelievably easy money policies.

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“Investors shouldn’t get hysterical but instead get historical,” Kristina Hooper, U.S. investment strategist at Allianz Global Investors, wrote in a note to clients.

Allianz found that in recent periods of rising rates, stocks initially retreated before stabilizing and eventually rallying as investors adjusted to the new environment. The firm cited two recent rising rate examples: a 7.36% advance by the S&P 500 in the 13 months after February 1994 and a 20.19% rally that began in July 2004.

Yellen-Fueled Panic

Yellen stirred angst on Wall Street last week during her inaugural press conference by answering a question about what the Fed meant by saying the federal funds target rate would remain in the 0% to 0.25% range for a “considerable time” after the end of QE.

The new Fed chief estimated this translated to about “six months,” meaning the first rate hike could come as soon as the second quarter of 2015.

The reaction from investors was initially very negative, with the Dow Industrials tumbling as much as 210 points before closing Fed Day down 114 points.

“Janet Yellen arguably created a bigger panic than if she had yelled, ‘Fire!’ in a crowded room,” said Hooper. “We think that investors overreacted to Yellen’s words.”

Wall Street bounced back the next day as investors reassessed the situation. Goldman Sachs (NYSE:GS) told clients it believes rate hikes are “far off,” likely not until 2016.

“Should investors be preparing today for the start of an interest rate tightening cycle that may be more than a year off? Mentally, yes, but otherwise, no,” Sam Stovall, chief investment strategist at Capital IQ, told clients in a recent note.

Weathering the Storm

Still, rates are eventually going to have to rise. By tracking the average monthly total returns of asset classes during months of rising 10-year Treasury note yields since the end of 1976, Capital IQ found the situation isn’t so bleak. In fact, only bonds posted an average negative monthly over that span, with the Barclays Aggregate Bond Index dropping 0.7%

On the other hand, the S&P 500 sported an average gain of 0.9% during those rising rate months and the S&P GSCI, which tracks commodities, enjoyed a rally of 1.1%.  Real estate investment trusts, or REITs, also posted steady gains during these months.

Stovall said the positive performance is probably because commodities, stocks and REITs are “natural inflation hedges” and higher rates are typically a “sign of improved economic conditions.”

Kenny notes that rising interest rates “can actually fuel credit demand,” so long as they don’t rise too rapidly.

“People are afraid to see rates rise outside of their appetite so they will go ahead and take a stab at a home loan or a second mortgage or to borrow money for college,” he said.

Breaking Point

As would be expected, the stock market tended to perform better when yields were closer to zero than when they brush up near 10%.

According to Capital IQ, the S&P 500 posted a median monthly gain of 1.9% since 1953 during months when the rising 10-year yield was at 3% or less. That growth slows to 1.7% when the 10-year is between 3% and 4% and 1.3% when it’s between 4% and 5%. By the time the rising yield is 5% to 6%, the S&P 500’s median one-month gain is still at 0.7%.

The breaking point appears to be the 6% level. Capital IQ said the S&P 500’s median one-month return is nil at the 6% to 7% yield range and then -0.5% once the 10-year climbs above 7%.

“Six is the magic number. Historically it means inflation that is going to have a deleterious impact on consumers’ buying power. Rather than looking to catch the wave, they are looking to stay out of the water,” said Kenny.

While 6% was the “line in the sand” during previous cycles, there’s no guarantee it will be this time around. In fact, Stovall and Kenny believe it may be lower this cycle because rates started from such a low level.

“There’s no question this recovery is different. We may see something closer to 5% be the tipping point where people are finding themselves unwilling to move in an aggressive manner,” said Kenny.

Winners and Losers

Given the varying risk profiles and financing needs of corporate America, there will undoubtedly be winners and losers in a rising rate environment.

According to Capital IQ, the more cyclical IT and energy sectors performed the best since 1970 during months of rising 10-year Treasury yields, posting average monthly returns of 0.76% and 0.72%, respectively.

Other sectors that averaged modest returns include materials, consumer discretionary and industrials.

On the other hand, the health-care and consumer-staples sectors averaged returns barely above zero and three sectors suffered declines: telecom services, financials and utilities, which averaged a 0.66% monthly decline.

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