Once again, panic runs rampant in the headlines of the financial world. Describing and understanding this market contraction proves difficult due to the sheer number of variables at play: the FED open market operations, interest rate hikes, Omicron, and the perceived overvaluation of high growth companies, to name a few. With that said, GDP numbers and earnings releases have been generally positive news – so why the drop in the markets? Let’s take a look at one of the variables that many people are pointing: rate hikes.
Interest rates increasing, at least in theory, devalues equity and outstanding bonds because the new higher-paying bonds are more attractive in comparison. Rate movement usually affects higher projected growth companies due to their capital costs. Obtaining capital and being highly leveraged poses more of a threat when you must pay back the debt at higher rates. Lastly, interest rates are an essential lever for regulators to pull to fight the threat of inflation.
All of these factors influence market movements, and exactly how they affect the investment environment is a discussion in itself. It is inherently impossible to accurately project the factors forward to predict the future. However, we can look at historical interest rate hikes and the market movements that followed them.
Before examining cases of particular time periods, it should be noted that we are reviewing interest rate hikes in a vacuum, separate from the multitude of other variables influencing the market’s behavior. Nevertheless, below are broad timelines of the FTSE US Market Index during and after interest rate increases. In each case, our hypothetical portfolio invested $100 into the broad market directly before the announcement of a rate hike.
1994: In early 1994, a rate hike cycle began – $100 invested at the beginning of the year would experience a string of rocky but flat months followed by significant gains, leading to a string of large gains and ending a 3-year period with a ~66% return.