The chart below comes from the Wall Street Journal, and is one I’ve shown before. I think it’s worth our time to reexamine it, because it contains a wealth of information that should help frame our outlook moving forward.
This chart looks at the past three rate hike cycles and tells a very enlightening story. In the left panel we can see the pace and duration of changes to the federal funds rate. The middle panel shows us how the longer end of the yield curve behaved during each rate hike cycle, and the right panel shows us what happened to the S&P 500.
First thing to notice (from the left panel), is that historically, once the Fed starts raising rates, it does not stop. This is why investors are so frightened about the upcoming initial rate increase, and why Yellen is spending so much time reiterating that the path of interest rates will not resemble that of past cycles.
This is also the scenario she is trying to avoid with her preference towards moving early. She does not want to fall behind the curve (terrible pun, I know) and be forced into a position where her dual mandate requires excessive and repeated tightening to calm an overheating economy.
The second panel provides another nugget of information, which is that the long-end of the yield curve does not always follow the short end. This is a very important concept to understand. There seems to be a widespread belief that an increase in the federal funds rate will tighten borrowing conditions across the board. That is not the case.
[Listen to: Axel Merk: The Fed May Raise Rates, But It Will Remain Behind the Curve]
The Fed’s control over the federal funds rate (the overnight rate that banks lend money to each other at) exerts the most control over the short end of the yield curve. The longer out you go on the yield curve, the less influence the Fed has. As you can see, in two out of the last three rate hike cycles, Fed rate hikes had little to no impact on the bellwether 10-Year Treasury rate.
Why is this important? Because it is the rate on the 10-Year Treasury that ultimately determines important conditions such as mortgage rates. The Fed can do all it wants with the short end, but if the 10-year doesn’t change, borrowing conditions for a large segment of our economy do not change.
The third panel may be the most relevant for equity investors. It shows how the S&P 500 behaved during the last three rate hike cycles. Notice that at the start of each cycle, the S&P corrected modestly. We can probably expect that to happen this time around as well. But also notice that eventually, stocks recovered and worked their way higher in all three cases.
From her most recent testimony, it is clear that Yellen is anticipating liftoff to occur sometime in 2015. But liftoff does not mean we will be climbing to a cruising altitude of 30,000 feet. Instead, we’re likely to keep skimming treetops until it’s clear that the economy can handle being further away from the zero bound.
The preceding content was an excerpt from Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
