The Trend in Interest Rates and the Impact on the Economy and Stock Market

The Federal Reserve raised interest rates and raised expectations for a fourth rate hike in December. The Fed unanimously agreed to raise the federal funds rate a quarter percentage point, to a range of 2% to 2.25%.

But, what does that mean?

The Federal Funds Rate is the interest rate at which depository institutions like banks and credit unions lend their reserve balances to other banks and credit unions overnight, on an uncollateralized basis. The U.S. Target Federal Funds Rate is at 2.00%, compared to the previous market day and 1.00% last year. This is lower than the long-term average of 2.61%.

The interest rate the borrowing bank pays to the lending bank to borrow the funds is negotiated between the two banks. The weighted average of this rate across all such transactions is the Effective Federal Funds Rate. The Effective Federal Funds Rate is at 1.91%, compared to 1.91% last month and 1.16% last year. This is lower than the long-term average of 4.83%.

Below we chart the trend of the Federal Funds Rate and the Effective Federal Funds Rate over the past 5 years. The trend in interest rates is clear.

Federal Funds Rate Interest Rates Effective Target

Why do we care about rising interest rates?

The Federal Funds Rate drives interest rates for mortgages, consumer loans, and credit cards. For example, loans based on the prime rate will be adjusted to reflect the trend in the Federal Funds Rate.

The rising trend in interest rates impacts many things beyond consumer credit cards. Ultimately, when the cost of borrowing increases it can impact real estate, homebuilders, and home construction as I pointed out in Rising Interest Rate Impact on Real Estate and Home Construction.

We haven’t seen the Federal Funds Rate this high in over 10 years.

Federal Funds Interest rate last 10 years

The Federal Funds Rate was much higher at around 4.5% at the peak of the stock market in October 2007. The Fed quickly and sharply lowered interest rates in response to the economic recession in 2008. The U.S. Fed kept a zero interest rate policy like Japan from December 2008 through December 2015.

federal funds rate since october 2007 bull market peak

Many investors wonder how the change in the directional trend of interest rates impacts the stock market. It is no surprise that mutual fund companies who want investors to keep their money invested in their funds that stay fully invested all the time will present data showing rising interest rates don’t impact stocks.

The Fed has been steadily raising rates to keep the U.S. from growing so fast that inflation gets out of hand. Increasing the cost of borrowing will likely slow down spending at some point for both consumers and capital spending of businesses.

The Federal Funds Rate seems to trend follow the stock market. Looking at a chart from the stock market peak in January 2000, we see the Fed Funds Rate was 6%. The Fed lowered the rate to around 2% during the -50% stock market decline and economic recession. I marked the recession in gray.

FED FUNDS RATE TREND FOLLOWING STOCKS ECONOMIC RECESSION

The Fed naturally increases and decreases the Fed Funds Rate in response to changing conditions.

After an economic expansion and the stock market appears highly valued, the Fed begins to raise interest rates to prevent inflation.

After the stock market declines and an economic recession, the Fed begins to lower interest rates to help stimulate recovery. In the chart above, we can see the zero interest rate policy after the crash of 2008 -2009 is abnormal.

Below is the trend Federal Funds Rate going back to the 1950’s. The interest rate has been much higher in the past, but not kept so low.

federal fed funds rate long term history trend following

Now that interest rates are trending up again it’s going to be interesting to observe how it impacts the economy and the stock market.

Many investment advisors and fund companies will probably try to use the data to show a silver lining. If your money is invested buy and hold into funds that are fully exposed to market risks all the time, those funds incentive is to keep you invested in them regardless of the level of risk.

I don’t believe market returns give us what we want over a full market cycle. After the stock indexes have gained for 10 years without a -20% or more bear market, many investors have probably become complacent with their exposures to market risks. That is especially true with one the longest bull market in history and the second highest valuation.

Along with long uptrends, we can experience devastating downtrends that result in large losses. That’s what we’ve experienced the past 25 years. The giant uptrend 1995 – 1999 was reversed from 2000 -2003. The uptrend 2003 to 2007 was reversed 2008 – 2009 and didn’t recover its 2007 high until 2013.

Rather than full exposure to market risk and reward all the time, I believe we must manage risk to increase and decrease exposure to the possibility of gain and loss.

It doesn’t matter how much the return is if the downside risk is so high you tap out before it’s achieved.

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

Rising Interest Rate Impact on Real Estate and Home Construction

The Federal Reserve raised interest rates today and raised expectations for a fourth rate hike in December. They unanimously agreed to raise the federal funds rate a quarter percentage point, to a range of 2% to 2.25%. The rate helps drive interest rates for mortgages, consumer loans, and credit cards. In 2019, the Fed expects at least three more rate hikes.

The rising trend in interest rates impacts many things beyond consumer credit. Ultimately, when the cost of borrowing increases it can impact real estate, homebuilders, and home construction.

The price trend of homebuilders and home construction stocks is down. The ETF of home builders and home construction stocks is down about -20% from their highs in January.

SPDR® S&P Homebuilders ETF XHB iShares Home Construction ETF $ITB

The price trends in Homebuilders stock ETF (XHB) and Home Construction ETF (ITB) show they really haven’t recovered from the fall that started in 2007.

home builders construction ETF sector ETFs

Below we add the 10-year treasury rate. Rising interest rates may be having some impact on real estate home builders and construction.

rising interest rates impact on housing real estate home builders construction

Rising interest rates are supposed to boost the profit margins of financials like banks and insurance. However, so far we observe the bank stocks and insurance stocks ETFs are trending mostly sideways since interest rates moved higher.

Bank ETF insurance ETFs rising interest rates

Another real estate sector is represented by the Real Estate sector ETF (XLRE), which seeks to provide precise exposure to companies from real estate management and development and REITs, excluding mortgage REITs. I shared some observations about the overall real esate sector earlier this year in Interest Rate Trend and Rate Sensitive Sector Stocks. The impact of rising rates has continued.

rising interest rate impact on real estate REIT

A clearer observation is seen in the chart of homebuilders stocks along with the trend in the 15-year and 30-year mortgage rate.

rising mortgage rate homebuilders home construction

Clearly, there seems to be some correlation between rising rates and falling real estate sector and industry groups like homebuilders and home construction stocks.

This is why I shift between markets and sectors based on their price trends instead of just allocating capital to them regardless of their directional trend. It’s also why we manage our risk in absolute terms with our intention of avoiding large losses created by significant down-trending price trends. I rotate between world markets rather than allocate to them.

 

Mike Shell is the Founder and Chief Investment Officer of Shell Capital Management, LLC, and the portfolio manager of ASYMMETRY® Global Tactical.

You can follow ASYMMETRY® Observations by click on on “Get Updates by Email” on the top right or follow us on Twitter.

The observations shared in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the potential loss of principal an investor must be willing to bear. Past performance is no guarantee of future results.

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