Central banks continue to tighten their monetary policies in the return to normal. For many months, the media has been hyping concerns over rising interest rates. As investors, should we be worried about interest rate hikes?
Here are some reasons to keep perspective in a rising rate environment:
Central banks: Good at communicating — While we may be used to the forward guidance given by central banks, it hasn’t always been this way. In the past, decisions made by central bankers were often a surprise that could rattle the markets. Consider that in the 1990s, investors used to guess what the Fed would do based on the size of then-Chair Alan Greenspan’s briefcase! The theory: if the Fed was going to change rates, Greenspan would be carrying a lot of documents so his briefcase would be wider. Today, we’ve been given ample warning by the central banks that rates will be rising, so much of this expectation continues to be built into the markets.
Interest rates need to normalize — Central banks have been highly accommodative for a very long time. Rates have been kept artificially low to help support economies during this challenging time. As we learn to manage the pandemic and return to normal, a natural unwinding needs to take place, which includes allowing rates to rise. However, let’s not forget that even with multiple rate increases, interest rates will still continue to be very low by historical levels.
Wealth levels continue to be high — With excess liquidity in the markets, many analysts suggest that central banks can hike rates quite a bit without affecting credit conditions. Many businesses continue to be in good shape financially, with solid balance sheets and excess cash reserves, so defaults on business loans are expected to be low. Household wealth also increased at all income levels during the pandemic, and delinquency levels on consumer loans are still at record lows.
Markets have historically performed well in rising rate times — Investing theory suggests that interest rates and stock prices move in opposite directions, as stock prices reflect the present value of future earnings: the higher the interest rate, the less future money is worth today. However, history has shown that markets can perform well during rising rates. One market strategist determined that the S&P 500 Index returned five percent in the six months following the first rate hike of past recent cycles, despite initial volatility. Other studies support positive equity market performance during rising interest rate environments (chart).
Slower economic growth — Recent economic data has been mixed to start the year. With the challenge of slower economic growth, and with emerging uncertainties from the geopolitical situation in Europe, it is likely that central bankers will be cautious in the pace of tightening, which may help to temper potential market volatility and may allow time for financial markets and economies to adjust.
This article was originally published in the Spring 2022 newsletter, "Challenging the Trend." Click here to view.