Sunday, January 11, 2015

Will Fed rate hikes crush the stock market?

A lot of common chatter suggests that stocks will suffer when the Fed starts hiking interest rates. This conventional wisdom is half right and half wrong. Fed monetary policy has three modes: accommodative or loose, neutral, and restrictive or tight. It is only when the Fed shifts from neutral to tight monetary policy to slow the economy that stocks could suffer. That doesn't mean that traders and speculators might not attempt to front-run the Fed long before we get to tight monetary policy, but we are literally years from that phase of monetary policy.

Currently, Fed monetary policy is extremely loose or accommodative. When the Fed makes its first rate hike in September monetary policy will remain very loose and have very negligible negative impact on the economy. Even at the end of the year when the fed funds target rate will be up to 0.75%, that is still incredibly loose and accommodative monetary policy. So, again, no headwind for stocks.

A neutral fed funds target rate is probably in the 3% to 4% range, call it 3.5%. The most recent report from the Fed suggested that they see the long-term rate at about 3.75%, in a range between 3.25% and 4.25%..

Even by the end of 2016, the current members of the Fed open market committee are expecting a rate in the 2% to 3% range, which is still well below the neutral range. IOW, even at the end of 2016, which is almost two years away, the Fed interest rate will remain very loose and accommodative, and hence not a worry for stocks.

And even after the Fed does reach neutral monetary policy, that does not mean that restrictive or tight monetary policy is right around the corner. We could see a healthy economy for several more years after that.

Rising interest rates can effect demand for dividend-paying stocks, but only when rates rise to a level so that T-bills and notes pay a comparable rate to the dividend yield. Typically stocks that pay a low dividend, such as under 1% or even 2% or 2.5% are only doing so to attract the attention of mutual funds that only invest in stocks that pay dividends, so a Fed interest rate up to about 3% will not be a problem for such stocks. Even stocks paying only a 2% to 2.5% dividend will remain attractive as long as their earning growth rate is sufficient to fund continual increases in the dividend rate, which is normally the case, especially in a growing economy, which is what we have and will continue to have with accommodative and neutral Fed interest rates.

To summarize, rising Fed interest rates will not offer any significant headwind for stocks for well more than another two years. So there is no need for investors to fret about rising interest rates in 2015.

-- Jack Krupansky


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