In order to assess the potential impact of an interest rate hike on asset markets it may help to understand the possible motivation behind the Fed’s decision. While they point to an improving economy, outside of their employment mandate there is little reason to raise rates. The Fed has also been clear about their desire to normalize interest rates and this is likely the reason policy makers will raise interest rates at the next available opportunity. The Fed is trying to get rates up to a point where when the economy falls into a recession they will have the ability to lower rates. Its important to understand that under the typical interest rate cycle the Fed is usually raising rates as the economy is about to overheat and create inflationary pressures. That is not what the Fed is trying to do in this cycle.
So what can we expect if the Fed raise rates in June? Last summer when rate hike talk surfaced the stock market responded poorly and experienced a swift and deep correction. By December stocks had staged a recovery and the Fed raised rates a quarter point. Markets proceeded to sell off aggressively as we entered 2016 only to recover by mid-April.
Will we see the same reaction from the stock market this time? Maybe not. Stocks have held up recently despite a mixed Q1 earnings season. Wednesdays initial stock market reaction to the Fed minutes was based on the surprise a rate hike was firmly on the table for June. At the time the futures market was projecting around a 5% chance of a June hike. It’s only around a 35% as of today. However, markets closed even on the day of the Fed release after being down earlier. On the following day they recovered a good portion of their moderate declines. As the stock market approaches the close of the week stocks are staging a rally. So far stocks appear to have taken a potential rate hike in stride. (I will post this note before the market close so take note of how they end the session for clues on how they may respond going forward.)
The bond market, on the other hand, could start to come under pressure. Bond investors have experienced a 35-year bull market and a move back to historical rates would cause fairly significant price declines for bonds with longer maturities. The bond market has moved to new highs since the December rate hike so the first hike had zero impact on the broader bond market. Bonds reacted poorly on the date of the Fed minutes release but stabilized the last couple of days. However, if the bond market sense more rate hikes are coming later this year you can expect downward pricing pressure to materialize. Depending on how high rates move the good news is investors will finally be able to receive a higher yield on their fixed income investments. But don’t count on it, we could easily see negative rates here in the U.S. before we see a 30-year Treasury bond yielding 5%.
The big risk for the Fed with a rate hike is the impact on the real estate activity. Whether you are talking about new construction, remodeling, refinancing and resale activity in both commercial and residential segments, activity is up. There is talk of a bubble in some markets and some ultra-high-end markets are seeing a slowdown, but generally speaking real estate activity appears to be good.
Part of the strength in real estate can be attributed to low interest rates and available credit markets. Rates have been higher at various stages of the current recovery so there is probably room for some hikes before rates start to deter the real estate market. We don’t know at what level interest rates will start to deter real estate borrowing and that is the tightrope the Fed must walk.
As I have said for many months, I believe healthy real estate activity is key to keeping this economy going. I don’t think a rate hike in June is going to derail things here in the U.S. and I expect one in June unless something significant changes between now and then. So far it looks like the stock market is going to take the hike in stride. The bond market, on the other hand, could come under pricing pressure especially if it feels additional hikes are coming. Real estate activity, I believe is the most critical component and one the Fed will not want to disrupt.