5 Things You Didn’t Know About Markets in a Rising Rate Environment

January 27, 2022

4-5 minutes reading time

In the initial wake of the pandemic, central banks pursued some of the most aggressive monetary policies in history. Now, two years later, low interest rates have propelled equity markets to new all-time highs, while bringing labour markets back to healthy pre-pandemic levels, and inflation to near 40-year highs.

Economists expect the Bank of Canada (BoC) to raise rates 5 times in 2022, while markets are pricing in up to 7 rate hikes. South of the border, the U.S. Federal Reserve (the Fed) is expected to hike rates between 3-5 times this year with a 99% chance that a rate hike will happen in the second half of 2022. Both central banks are widely expected to announce their first rate hike in March.

The actual timing of these interest rate increases doesn’t really matter. What matters is that for the first time since 2018, we are in a rising rate environment. And for the millions of people (about 15% of all retail investors, to be exact) that invested for the first time during 2020 - these are uncharted waters.

Sure, equity markets have been choppy lately, but if you are under the impression that raising rates are detrimental to markets and the economy, you’re likely being misled by the headlines. The numbers, as always, tell a different story.

1 - Rate hikes are priced in well before they actually happen

Interest rates affect the pricing of all asset classes - including currencies, commodities, fixed income, and of course equities. A lot here is at stake - and you can bet large institutional investors (who track markets 24/7) anticipate and race to adjust their portfolios well ahead of central bank announcements. 

This means by the time central banks actually raise policy rates, asset prices have already “priced in” the increase. In other words, by the time you read about rate hikes, you’re already too late!

2 - Equities actually perform pretty well

Higher interest rates mean a higher cost of capital for businesses - which can hurt equity valuations in the short run.

Even still, our research shows that large-cap stocks have actually performed fairly well in rising rate environments.

Source: Refinitiv, Federal Reserve Bank of St. Louis (FRED). The federal funds rate is represented by the absolute change in the average effective federal funds rate on a year-over-year basis. S&P 500 total returns are shown in USD.

It may come as a surprise that the S&P 500 has only had two losing years since 1990 when the federal funds rate has increased year-over-year. In those two years, 2000 and 2018, the S&P 500 declined 9.1% and 4.4%, respectively. In contrast, the average rate of return across all years of rising rates was +12.90% over the same period.

With 2022 off to a less than stellar start for stocks, it might be hard to believe that equities actually perform well while rates are rising. However, history shows that this market behaviour is fairly common.

The start of a rate hike cycle is often met with temporary market volatility. 4 of the last 5 Fed rate hike cycles saw an initial >5% pullback, but in each case, the stock market rallied over the next 12 months to finish in the green.  

Although rising rates increase a company’s cost of capital, it is important to remember that the central banks only raise rates when the economy is strong. And a strong economy means strong corporate earnings growth.

3 - Whoever said rising rates are for bonds was wrong

It is generally known that bond yields and bond prices have an inverse relationship: when bond yields rise, bond prices fall, and vice versa. 

What is often overlooked here is that bond markets are affected by the entire yield curve, and central bank policy rates really only affect the short end of the curve. Changes in long-term bond yields, such as a government 10-year, have a much bigger impact on bond markets.

Our research shows that since 1990, major fixed income asset classes have actually posted positive average returns in years when rates have been rising. 

Source: Federal Reserve Bank of St. Louis (FRED), S&P Dow Jones. The years shown are only years in which the average Federal funds rate increased on a YoY basis since 1990. T-Bill return is based on the average rate over the course of each year. Returns shown in USD.

While it may be tempting during this period of market volatility to de-risk your portfolio and load up on T-Bills, they were still the worst-performing fixed income sector in rising rate years. The exact opposite was true for high-yield bonds.

4 - Other asset classes have also held up well

Source: Refinitiv, MSCI, Nareit, S&P Dow Jones, Eurekahedge. Returns shown in USD.

Historically, it hasn’t just been stock and bonds that have held up well in rising rate environments. Other asset classes have also fared well.

Although infrastructure and real estate investments rely heavily on debt financing, where the interest burden increases as rates rise, both asset classes have performed well.

When rates rise due to higher inflation, listed infrastructure companies have a proven ability to pass on the costs of higher inflation to their customers. 

As for real estate, rising interest rates are frequently associated with economic growth and rising inflation, both of which are typically positive for real estate investments as economic growth tends to translate into greater demand for real estate and higher occupancy rates.

Although central banks typically raise rates to curb economic growth when inflation is running hot and commodity prices move in tandem with inflation, commodities have actually performed well in rising rate environments. 

Alternative investment strategies also performed well in rising rate environments, demonstrating the value of active management and its ability to navigate changing market conditions. 

5 - Although nominal rates are rising, real rates are still negative

With the 10-year Treasury nominal yield rising to 1.81%, there’s been no shortage of “rising rates'' headlines. And yet, the 10-year Treasury real yield remains at -0.53% and has been negative for the last two years. 

Source: Federal Reserve Bank of St. Louis (FRED)

The current 10-year Treasury real rate is well below its 15-year average of 0.54%, which means that current conditions are still broadly stimulative. 

While markets have recently pulled back following hawkish announcements from central banks, it is important to remember that there is a difference between tightening and overtightening when it comes to monetary policy. Rates have a long way to go before they start to restrict economic growth.

Where to from here? 

The pullback we have seen so far in January is just part of the normal market cycle. 

Since 1950, the S&P 500 has had an average annual intra-year drawdown of 13.6%. And yet in the same period, it has managed to post an annualized total return of 11.6%.

While we’re certainly not predicting that 2022 will be rosy across the board, we’re simply urging our readers to think beyond the headlines and focus on the bigger picture.

Interest rates are rising because policymakers have growing confidence that the economy is on solid footing, and that companies are in a stronger position to withstand higher costs of capital. In the broader economic cycle, rising interest rates mean we’re only in its mid-phase of expansion - there’s still ample juice left. 

How long the current cycle lasts partially depends on whether central banks can manage to normalize interest rates by just the right amount - too little and risk inflation running even hotter, too much and risk prematurely ending the expansion cycle.

Interest rates are just one of many factors that drive asset price volatility, which is why it’s important to have diversified, actively managed portfolios that can weather through various market conditions. In the long run, the biggest risk to investors is simply not investing.

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