The Fed's rate hikes aren't going to kill this bull market

Some people think that the Fed’s rate hikes are bearish for this bull market. They believe that if the Fed hikes interest rates “too much”, this bull market will die prematurely. They are wrong on two accounts.

  1. When the Federal Reserve hikes interest rates, it’s actually a good sign for the economy. It means that the economy is improving. The Fed will only hike rates if the economy is getting better nominally, and we know that an improving economy is good for the US stock market. Rate hikes are only bad for the economy when inflation gets out of control and real growth turns negative. Inflation is low and U.S. economic growth is robust right now. Hence, rate hikes are a badge of honor symbolizing this strong economy. Three rate hikes per year is not going to have a significant impact on the economy.
  2. The Fed has only hiked rates 3 times thus far in this economic expansion. The Fed typically hikes interest rates many more times before a bull market tops. Interest rates are far from being “too high”.

Our model states that this is still a bull market for U.S. equities. This bull market still has at least 1-2 years left. Our model does not use interest rates as a component.

# of historical rate hikes before bull markets peaked

Since 1950, there have only been 4 bull market tops: 1968, 1972, 2000, and 2007. Some of these bull markets lasted decades, which means that within the specific bull markets there were periods of rate hikes, followed by rate cuts, followed by rate hikes…
But in the last leg of each bull market, the Fed always hiked rates multiple times.
Before 2007
The Fed started to hike rates in 2004, more than 3 years before the bull market topped. The Fed hiked rates 17 times from 1% to 5.25%.

Before 2000
After cutting rates in 1998 to deal with the fallout from the Russian financial crisis, the Fed started to hike rates again in 1999. The Fed hiked rates 6 times in less than 1 year from 4.75% to 6.5%.
But it’s important to remember that during this bull market, interest rates were lowest in 1992-1994 (3%). So from this perspective, the Fed started its rate hike cycle 6 years before the stock market peaked in 2000.

Before 1972
*The Fed changed interest rates much more frequently in the 1970s and 1960s due to the high levels of inflation at the time.
The Fed began a general rate hike path in 1971. (There were some months when the Fed would cut rates, which would be followed by rate hikes in later months). Overall, the Fed hiked rates from 3.5% to 6% in 1971 and 1972.
Many of these rate hikes were aggressive (i.e. hikes of more than 1% at a time).
Before 1968
The Fed hiked rates aggressively from 3.75% in 1967 to 6% by the end of 1968.

Bottom line

Rate hikes should not concern investors. People are mistaken to think that rate hikes kill economic expansions. That’s not true. The tail doesn’t wag the dog.
The Fed is forced to hike rates in an economic expansion because the economy is improving. As the economy improves, interest rates are going up on their own because demand for loans increases or inflationary pressures are rising. The Fed has no choice but to hike rates, otherwise they’ll be too far behind the curve.
When the economic expansion ends, it doesn’t end because rates are too high. It ends because there are cycles in everything and the economic growth is tapped out. (Conversely, that’s also why rate cuts can’t stop recessions.) High interest rates are just a symptom of the end of an economic expansion and bull market. High rates do not cause the bear market and recession.
This is why sometimes the Fed can only raise rates a few times before the economy sputters, while in other cases the Fed can raise rates many times before the economy sputters.
Focus on the state of the economy and ignore the Fed’s actions. In the long term, the market and economy are going to go where they’re suppose to go, with or without the Fed.

The next small correction

During the current rate hike cycle, the S&P 500 always sold off after the Fed hiked rates. There were 3 cases. Sometimes the S&P made a pullback, and sometimes it made a correction.

If the Fed hikes rates on June 14 2017, the U.S. stock market will probably start a small correction right now. Friday’s mini-crash in tech stocks also has bearish implications for the broad stock market, historically speaking.

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