Investors in the United States seem fixated on a gloomy outlook for 2015, in which the Federal Reserve's efforts to remove economic stimulus cause stock and bond prices to fall. They're missing an important detail: If the Fed raises short- term interest rates above those in other major economies, U.S. markets may actually benefit.
Investors have displayed a frantic aversion to signals that a long period of near-zero U.S. interest rates is coming to an end. In the two weeks prior to the Fed's Dec. 17 policy meeting, the S&P 500 tumbled more than 5 percent amid concerns that improved economic data would prompt the central bank to raise its short-term interest-rate target sooner. When the Fed issued a statement that suggested it was willing to wait, stocks rebounded to a series of all-time highs.
A more hawkish Fed, though, need not trigger the disaster that markets fear. Specifically, over the last two decades, U.S. equities have logged average annualized returns of 10.7 percent when the Fed's interest-rate target has exceeded that of the relevant central banks in Europe, compared to just 1.2 percent when it hasn't. An analysis of recent interest-rate cycles suggests this relationship is more than a mere correlation.
When the Fed began raising rates in January of 1994, stocks initially struggled, with the S&P 500 falling 7.7 percent by June. But after September, when the Fed's target rate exceeded those of the German Bundesbank and the Bank of England, the dynamic changed: The S&P returned 26.3 percent over the next 12 months. The same happened in 2005. Stocks started gaining as soon as the Fed's target rose above those of its European peers. Stocks also performed well during the rate hikes of 1999, when U.S. short-term rates were already higher than Europe's.
What might explain this phenomenon? The dollar and the euro (or, prior to 1999, the German mark), as the world's two primary reserve currencies, are constantly competing for investors' money, which tends to flow toward the currency that offers the highest yield. So when the Fed raises short-term interest rates above those in Europe, investors pile into the U.S., strengthening the dollar and pushing up asset prices. This, in any case, is what has happened during the last three periods of rate increases.
The Fed's target rate is currently lower than the European Central Bank's, which stands at 0.5 percent. Hence, a gradual rate increase in the U.S. will keep monetary policy historically loose but also produce a significant yield advantage. Attracted by the prospect of dollar appreciation and economic growth, investors will likely snap up U.S. equities, particularly dividend-rich stocks.
Bonds should benefit, too, holding long-term interest rates low relative to short-term rates. Historically, at times when the Fed's target rate has exceeded the ECB's, the yield on the 10-year U.S. Treasury note has on average been just 0.09 percentage point higher that the Fed's rate. That compares to 2.37 percentage points when the ECB's target rate has exceeded the Fed's. The narrower gap will help keep credit flowing to companies and support mergers-and-acquisitions activity even as short-term rates rise.
To be sure, none of this will completely insulate the U.S. from economic malaise in Europe and Japan and any further fallout from Russia's incursions in Ukraine. That said, a more hawkish Fed should not prove to be the market's undoing. Rather, it is far more likely to provide shelter from the storm.
Matthew Schoenfeld is an analyst at Driehaus Capital Management.