Higher Rates Will Dominate Markets in 2016

Will the Federal Reserve’s decision in December to start raising interest rates for the first time in nearly a decade help deflate the same stock market bubble the central bank has been accused of helping to inflate over the course of the market’s six-year bull run?

Analysts believe much of how the stock market reacts to higher interest rates in 2016 will likely depend on how the Fed communicates future rate hikes.

“Modern central banking is as much an exercise in effective communication as it is economic analysis. Something simple like ‘We’re going to raise rates’ is fairly straightforward, even if it took the Fed the better part of a year to get it across to capital markets,” said Nicholas Colas, chief market strategist at Convergex, a global brokerage company based in New York, in a recent research note.

“Now, they must set the stage for future hikes.  Threading that needle will take time and (the Fed’s December) meeting is still early days for this effort,” Colas added.

It’s one of Wall Street’s oldest clichés but its truth is undeniable: markets (ie., investors) hate uncertainty. So conventional wisdom holds that the more skillful Fed officials are at telegraphing their upcoming rate hikes, the less volatile markets will be once those hikes are announced.

Let’s get one thing clear from the outset: the actual financial impact of the Fed’s initial rate hike will be minimal. After all, the Fed merely raised rates by 0.25% from the near-zero range where they’d been held for seven years in the wake of the 2008 financial crisis.

Fed Chair Janet Yellen emphasized this point in her press conference following the announcement of liftoff. “We have very low rates and we have made a very small move,” Yellen said in response to a question of how the move toward higher rates might impact consumers and the broader economy going forward.

Most analysts believe the Fed is targeting, at most, two additional rate hikes in 2016, each one another boost of 0.25%, and only if the economy seems to be responding well to the first rate hike. That would leave the benchmark fed funds rate at 1.50% by the end of next year, still well below the 5.25% level where rates stood just ahead of the financial crisis.

U.S. stock markets have been on a meteoric bull run since the recession ended in 2009. The S&P 500, the broadest measure of U.S. stocks, has risen more than 200% since hitting a recession low of 683 in March 2009.

Much of the fuel for that bull market was supplied by the Fed’s unprecedented easy-money policies, namely rock-bottom interest rates and a massive bond purchasing program known as quantitative easing. Those policies pumped trillions of dollars of cash into the financial system, money that had to go somewhere. And with interest rates at near-zero, money poured into stock markets in lieu of investments such as CDs and long-term bonds whose returns are closely tied to interest rates.

Since the Fed had so carefully telegraphed its December rate hike, markets responded with little volatility. What happens in 2016 is really anyone’s guess, but stock markets are likely to follow the Fed’s lead: if the Fed communicates well and markets are prepared for whatever actions are taken by the central bank, investors will respond accordingly. If, however, the Fed seems indecisive or lacks a unified message, all bets are off.

In any case, if history is any indicator (and it usually is) stock markets may not see much upward movement in 2016 regardless of how well the Fed communicates its message. In a research report released in November, Goldman Sachs said U.S. stocks will spend another year flatlining in 2016 as investors feel the impact of higher interest rates on stock valuations.

“In 2016 the key focus of all market participants will be the path of ongoing interest rate normalization,” the analysts wrote.

Goldman forecasted that the S&P 500, the stock index favored by most equities analysts, will end 2016 at 2100, or 1% above its current level of 2059 (when the report was written). The index is up about 1.6% year-to-date in 2015.

“We forecast the S&P 500 index will tread water for a second consecutive year in 2016,” the analysts wrote.