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Market View

A look at the last five rate-hike cycles could offer some clues about the next one.

The big investment question for 2015—when will the U.S. Federal Reserve begin hiking the federal funds rate, and by how much?—is closer to being answered. In a report issued at the conclusion of the meeting of the policy-setting arm of the Fed, the Federal Open Market Committee (FOMC), on June 16–17, 2015, 15 of 17 Fed officials said they expected the Fed to begin raising short-term interest rates before the end of 2015. The Fed has four more meetings scheduled for 2015—in July, September, October, and December—with markets expecting the first rate hike in September.

What might this mean for investors? One way to assess the potential impact is to look at history, although past performance is not a guarantee of future results. Earlier this year, for example, Zane Brown, Lord Abbett Partner and Fixed Income Strategist, wrote a series of articles exploring how key U.S. fixed-income categories and large-cap equities performed during the past five periods of a rising fed funds rate. And now because the June 17th Fed projections emphasize just how close the central bank is to delivering its first rate hike, we thought it would be a good time to summarize those findings.

Let’s first look at the historical fed funds rate, and the most recent projections for where the rate could be headed (see Chart 1). We’ll start in the early 1980s, just after the overnight rate had peaked at nearly 20% in response to the inflation crisis back then. From this starting point, we can view the five distinct periods when the FOMC raised the fed funds target rate—some very rapidly, as in 1994, and others over a longer time period, such as during 2004–06. To see where the rate might be going in 2015, we include two sets of projections: 1) a dashed line evenly connecting the median points from the Fed “dot-plot” predictions (from the 17 members), and 2) the rate priced into the fed funds rate futures market for the next three years. Fortunately for investors, both sets of projections indicate the kind of “gradual” rate increase that the Fed chairwoman Janet Yellen has stressed.

 

Chart 1. Where Has the Fed Funds Rate Been—and Where Could It Be Headed?
Fed funds target rate (December 31, 1984–June 19, 2015) and indicated projections of future rates

Source: Federal Reserve and Bloomberg. Percentage figures accompanying arrows refer to the size of the total increase in the fed funds rate during the indicated period. Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

 

Now that we’ve mapped the interest-rate landscape, let’s turn back to those last five fed rate-hike periods and summarize the performance of various segments of the bond and stock markets during each period to assess how markets might react in the coming years. We present this performance in Table 1. Then, we offer some of Brown’s observations about what the historical record suggests for each of these sectors when the Fed begins the next phase of interest-rate hikes. [Of course, past performance is no guarantee of future results.]

 

Table 1. How Have Key Asset Classes Performed during Past Periods of Fed Rate Hikes?
Total return by index during indicated periods of Federal Reserve rate hikes

Source: Federal Reserve Bank of New York, Citigroup, Barclays, BofA Merrill Lynch, and S&P Dow Jones Indices. Two-Year U.S. Treasury = Citi Treasury Benchmark 2-Year Index. 10-Year U.S. Treasury = Citi Treasury Benchmark 10-Year Index. Barclays Aggregate = Barclays U.S. Aggregate Bond Index. Short Corporate Bonds = The BofA Merrill Lynch 1-3 Year U.S. Corporate Index. Floating Rate Loans = Credit Suisse Leveraged Loan Index (historical data for this index is monthly; returns reflect nearest month-end). High Yield Bonds = BofA Merrill Lynch High Yield Index. S&P 500 = S&P 500 Index.
Past performance is no guarantee of future results. The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Due to market volatility, the market may not perform in a similar manner in the future.
The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

 

U.S. Treasuries
The performance of U.S. government bonds during the five periods in our survey was largely a function of the bonds’ maturity. The lower duration, or price responsiveness to interest-rate changes, of a representative two-year U.S. Treasury index allowed a positive return in every cycle and an average return of 2.41% during these periods. The story changes dramatically farther out on the yield curve, as an index of 10-year U.S. Treasury securities posted an average return of -1.87%.

Short-Term Corporate Securities (Short Duration)
The performance picture improved greatly outside the government-bond sector during the rate-hike periods in our survey. A representative index of one- to three-year investment-grade corporate securities handily outperformed both classes of U.S. Treasury securities in each of the past five Fed rate-hike episodes. This outperformance came despite the fact that in every cycle, except 1986–87, the yield on two-year Treasuries rose substantially more in than did that of 10-year Treasuries.

Since short-term bond yields are more closely tied to the fed funds rate than are longer-maturity bond yields, one might ask whether short-maturity bonds would be more susceptible to losses when the Fed begins to raise rates. To that point, note that when the Fed tightens, short-term yields increase more than long-term bond yields, causing the curve to "flatten." So, does this mean that investors should avoid short-term bonds? Apparently not, since history suggests otherwise.

It is true that short-term yields tend to rise more than long-term yields during Fed-tightening cycles, leading to a flattening of the Treasury curve. However, during such periods, short maturities historically have delivered positive returns, despite rising yields. The higher income generated by short-maturity, credit-sensitive sectors offer greater prospects for returns in the face of rising rates.

Bank Loans
There have been three Fed-tightening cycles since 1992, which is the beginning of reliable bank-loan index data. The three episodes that began in 1994, 2000, and 2004 represent a range of rate hikes and time frames. In each case, bank loans (as measured by the Credit Suisse Leveraged Loan Index) performed well relative to the alternatives. The three-cycle average performance of 6.04% for the representative leveraged-loan index compares favorably to 2.41% and 1.02%, respectively for the two-year U.S. Treasury index and the Barclays U.S. Aggregate Bond Index.

While past performance is no guarantee that bank loans will again perform in a similar manner in the next rate-hike cycle, the “data-dependent” nature of the Fed’s upcoming policy decisions suggests initial rate hikes likely will coincide with evidence of self-sustaining U.S. economic strength. More robust U.S. growth likely would also support the economically sensitive bank loan sector. Based on current valuation measures, the bank loan sector offers potentially attractive relative returns, almost regardless of when the Fed chooses to hike rates. 

High Yield
What has happened to the U.S. high-yield sector when the Fed has raised interest rates? In every period but the interval of June 1999–May 2000, the representative BofA Merrill Lynch High Yield Index outperformed the Barclays U.S. Aggregate Bond Index. The high-yield index also returned more than the two-year U.S. Treasury note during three of these five periods. If we combine all five periods, the high-yield index provided an average return of 3.84%, compared to 1.21% for the Barclays Aggregate Index and 2.42% for the two-year Treasury Index. 

This is no guarantee that high yield will outperform when the Fed’s widely anticipated policy tightening finally takes place. However, the historical returns of the high-yield index imply economic sensitivity, rather than rate sensitivity, for the asset class, and the importance of the higher yield that accrues over time. The criteria that favor rate hikes—stronger economic growth and slightly higher inflation—seem to argue for U.S. high-yield securities, regardless of whether those conditions allow the Fed to launch an interest-rate “liftoff” in September or later in 2015.

U.S. Large-Cap Equities
In four out of five periods, returns on the representative S&P 500® Index outperformed that of a conservative strategy which invested in two-year U.S. Treasury notes. The surprise Fed tightening in 1994 was the one period when the two-year Treasury performed better than the S&P 500. Over the five tightening cycles, average S&P 500 performance of 13.71% compares favorably to the 2.41% average for the two-year strategy. Even if we were to exclude the extraordinary S&P 500 return of 35.35% at the period beginning in late 1986, the average outperformance of equities versus two-year Treasury securities during the past five Fed-tightening cycles is meaningful.

Historically, the Fed has raised rates to temper excessive economic growth and contain or lower inflation. The Fed’s current objective is instead to normalize interest rates without adversely affecting economic growth. Arguably, this more economy-friendly objective could favor equities and other economically sensitive securities more than past rate-hike policies have, when economic slowdown was part of the objective. Thus, if the Fed is successful in its implementation of rate hikes, interest rates can move gradually higher without seriously affecting the economic growth that supports corporate earnings and, in turn, equity valuations.

Summing Up
Whether the Fed decides to tighten as early as July, or as late as December 2015 (or even later), market anticipation of rate hikes suggests that some fine-tuning of fixed-income portfolios now may be appropriate. Equity investors also may decide to reassess their approach as they await the Fed’s next move. Regardless of an investor’s appetite for risk, there have been a number of investment strategies that historically have worked well. Investors may wish to review them as the day of rate-hike reckoning approaches.

 

MARKET VIEW PDFs


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