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Surprisingly Benign: How Stocks Respond to Hikes in Fed Funds Rate

Ginnie Baker

On May 4, the US Federal Reserve increased the target federal funds rate1 by 50 basis points as part of what the central bank said will be a series of rate increases to combat soaring inflation in the US. Some investors may worry that rising interest rates will decrease equity valuations and therefore lead to relatively poor equity market performance. However, history offers good news: Equity returns in the US have been positive on average following hikes in the fed funds rate.

A study of the relation between US equity returns, measured by the Fama/French Total US Market Research Index, and changes in the federal funds target rate from 1983 to 2021, shows over this period of 468 months, rates increased in 70 months and decreased in 67 months. Exhibit 1 presents the average monthly returns of US equities in months when there is an increase, decrease, or no change in the target rate. On average, US equity market returns are reliably positive in months with increases in target rates.2 Moreover, the average stock market return in those months is similar to the average return in months with decreases or no changes in target rates.

What about the months after rate hikes? This question may be of particular interest when the Fed is expected to increase the federal funds target rate multiple times. Exhibit 2 presents annualized US equity market returns over the one-, three-, and five-year periods following one or two consecutive monthly increases in the fed funds target rate, as well as following months with no increase. In reassuring news for investors concerned with the current environment of increasing rates, the US equity market has delivered strong longer-term performance on average regardless of activity at the Fed.

With a number of Federal Open Market Committee meetings remaining in 2022, the Fed’s signals and actions will continue to be closely watched by the market. As the Fed often signals its agenda in advance, we believe market participants are already incorporating this information into market prices. While it’s natural to wonder what the Fed’s actions mean for equity performance, our research indicates that US equity markets offer positive returns on average following rate hikes. Thus, reducing equity allocations in anticipation of, or in reaction to, fed funds rate increases is unlikely to lead to better investment outcomes. Instead, investors who maintain a broadly diversified portfolio and use information in market prices to systematically focus on higher expected returns may be better positioned for long-term investment success.

Footnotes:

  1. The federal funds rate is the interest rate at which depository institutions lend balances at the US Federal Reserve to other depository institutions overnight.
  2. The Federal Open Market Committee (FOMC) holds eight regularly scheduled meetings per year and may not change the target rate at every meeting. The FOMC may also change the target rate multiple times within the same month; in such instances, we aggregate all changes by month.

Required Disclosures: PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Beaird Harris Wealth Management, LLC -“Beaird Harris”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Beaird Harris.

Please remember that if you are a Beaird Harris client, it remains your responsibility to advise Beaird Harris, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Beaird Harris is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of Beaird Harris’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request.

Beaird Harris does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to Beaird Harris web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

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