No one, with the possible exceptions of Federal Reserve Chairwoman Janet Yellen or Vice Chair Stanley Fischer, can say with any certainty whether the Fed will raise the interest rate this year. The move, however, has been telegraphed to the point that most investors are well aware a hike is coming and have been anticipating it with trepidation. This unease, however, is likely misplaced. History suggests that, while stocks may initially react negatively to an interest rate increase, more often than not, equities recover and move higher within two years of an initial rate increase.

Evidence suggests that any decline in equities would likely be short lived following an initial hike.


Historically Low Levels – more than six years of near-zero interest rates

In December 2008, the Fed cut the federal funds rate to a record-low range of 0% to .25% and hasn’t touched it since. It’s hard to argue that the December 2008 cut hasn’t achieved the desired outcome. Economic growth, though slower than in previous recoveries, has returned, with the GDP logging a 3.7% increase for the second quarter. And with the unemployment rate down to 5.3% – it’s lowest level in seven years – the overriding consensus is that the economy has improved to the point that a rate hike by year-end is likely, a prospect that is supported by core inflation that currently resides at 1.8%.

Stock Market Anticipation and Reaction –
longer-term optimism but short-term caution

It’s natural that investors may be concerned with the prospect of a Fed rate hike, given the 200% move in the S&P 500 that began shortly after the rate cut. The evidence, however, as reflected in the chart below, suggests that any decline would likely be short lived following an initial hike. This temporary weakness is typically followed by a period of stabilization and then a move higher within two years of the rate increase. The last three rate increases, for instance, resulted in modest declines in the S&P 500 during the ensuing three months, but the Index recovered its losses, on average, within six months, and performed well in the two years following the first rate increase.


Key determinants – pace and level of rate hikes

The magnitude and pace of rate hikes will have a great deal to do with how the stock market reacts. If, as expected, the Fed takes a measured approach to the process, equity markets are likely to react favorably. For this reason, the Fed has taken pains to telegraph its strategy around interest rates, recognizing that an accelerated or uneven pace would likely be met with consternation from equity investors, not to mention additional handwringing from global central bank officials.

As can be seen above, the highest market return occurred when the Fed began raising the rate from a base of 1.25% in 2004. The S&P 500 declined initially but in two years following the hike was up over 35 percent. An interest rate increase from the current near-zero level is uncharted territory. Even an increase of a couple of percentage points would leave the rate low relative to where it’s been historically while positioning the Fed to act in the event of a deteriorating economic picture.

Fed Chairwoman Janet Yellen has emphasized that the Fed will not necessarily raise rates in successive meetings, highlighting that future increases could occur more slowly than in the past.

“Although policy will be data dependent, economic conditions are currently anticipated to evolve in a manner that will warrant only gradual increases in the target federal-funds rate,” Yellen said in a June 17, 2015 press conference following the Fed’s June policy meeting.

The Fed expects its benchmark short-term interest rate to remain below 3% through December 2017. Keep in mind, even at 3%, the benchmark would reside far lower than where it has been for the past half century this long into an economic expansion.

With the coming increase in interest rates expected, investors will certainly want to reassess where they may be exposed. While the hike may lend itself to some initial volatility, history suggests that the two-year trajectory should bode well for those who don’t panic.