On March 16, 2022, the Federal Reserve approved its first rate hike since December 2018. The Federal Reserve has been more aggressive than expected, indicating it plans to raise interest rates at each of the six remaining meetings in 2022. It is now assumed that by the end of 2022, the Fed Funds Rate will fall between 1.75% and 2 % lying down.

The committee sees three more increases in 2023 and none the following year. Could the Fed Funds Rate Really Reach 2.5 to 2.75% by End of 2023? If inflation remains above 6% in 2022 and above 4% in 2023, the chances are high. But a lot could change in the next two years for the Fed to shut down.

Stock Market Performance Over Past Fed-Rate-Hike Cycles - Fed Funds Rate vs. CPI

If the Fed follows a gradual 0.25% hike at each meeting, the impact on borrowing costs won’t be as great. Consumers with variable rates have sufficient time to refinance to a fixed rate. Furthermore, government bond yields will not necessarily follow the Fed Funds Rate higher in lockstep. That is why the mortgage interest rate should not rise so much.

In this article, let’s discuss how the stock market has historically performed during cycles of Fed rate hikes. We’ll also look at how specific sectors have performed when interest rates rise.

How Fed rate hikes affect stock market returns

Great news! During the previous four rate hike cycles, equity markets ended up doing well over the next 12 months.

Check out this awesome chart created by LPL Research and Bloomberg. It shows that three months, six months and twelve months after the first rate hike, the S&P 500 is positive 50%, 75% and 100% of the time.

How the Stock Market Has Performed During Fed Rate-Hike Cycles

That’s why we need to stay invested for as long as possible based on historical performance. Tell yourself you’ll last at least a year. Instead of selling stocks during a correction or bear market, it may be better to buy stocks.

The only time we should sell stocks is when we realize our risk exposure is too great. And the only way to really know if our exposure to risk is too great is to go through a down market and analyze how you’re feeling.

During up markets we tend to be more risky than we really are. It’s easy to confuse brains and courage during a bull market.

How S&P 500 Sectors Perform in Fed Rate-Hike Cycles

Here’s a great chart from Strategas Securities breaking down the average annualized returns by S&P 500 sector during Fed rate hike cycles. Technology, real estate, energy, healthcare and utilities performed best, outperforming the S&P 500 as interest rates rose.

How the S&P 500 sectors are performing in Fed rate hike cycles

Why tech stocks perform better in a rising interest rate environment

Some of you may be surprised that the technology sector has been the best performing S&P 500 sector during historic Fed rate hikes. The technology sector tends to be more sensitive to rising interest rates, as a higher discount rate lowers the present value of expected cash flow when performing a DCF analysis. Technology stocks tend to trade more based on expected future earnings, which are more uncertain, compared to, say, the utilities sector.

However, the empirical evidence shows otherwise.

One reason the S&P 500’s tech earnings are less sensitive to changes in interest rates than other S&P 500 sector earnings is that tech companies tend to have less debt financing than non-tech sectors. Gorillas like Apple, Google and Microsoft are dairy cows with huge balance sheets. Therefore, they would actually earn higher interest income than those companies with weaker balance sheets if interest rates rise.

Another reason the technology sector tends to perform well during a cycle of Fed rate hikes is that technology stocks don’t sell expensive items to fund their customers. For example, most people who buy Apple Air Pods can pay in cash or charge it to a credit card and pay after one billing cycle. The same goes for subscribing to cloud software.

Here’s an interesting chart showing how valuations for the S&P 500’s technology sector sometimes rise as 10-year Treasury yields rise. Fascinating stuff!

Why the tech sector outperforms during a Fed rate hike cycle?

With many technology stocks slumped since November 2021, investing in technology stocks now seems more attractive. I buy more shares in technology leaders like Google, Amazon, Nvidia and Apple. I have owned these names for years. I also nibble on bombed-out names like DocuSign and Affirm. Please do your own due diligence.

Why real estate tends to outperform when interest rates rise?

The real estate sector is generally doing well because real estate benefits more from rising rents than it is harmed by rising mortgage rates. Furthermore, since real estate is an important part of inflation, real estate tends to move with the inflation wave.

The Federal Reserve tends to increase the Fed Funds Rate in a strong economic environment, not a weak one. Therefore, real estate tends to outperform when interest rates rise, as the strength of the labor market, corporate earnings and wage growth overwhelm rising borrowing costs.

But here’s a point worth repeating. Mortgage rates don’t necessarily rise as much as the Fed raises rates. Check out this chart from Federal Reserve Economic Data (FRED) comparing the average 30-year fixed rate mortgage and the effective interest rate of the Federal Funds.

30-Year Fixed Rate Mortgage Rate vs. Effective Federal Funds Rate Since the 1970s through 2020

Where will mortgage rates be at the end of the Fed’s rate hike cycle?

There are two main observations from the chart above.

The first observation is that interest rates have been falling since the 1980s. Therefore, it is a better move to take out a floating rate (ARM) mortgage over a 30 year fixed rate mortgage. You can refinance before the ARM adjusts or if it does adjust, chances are the price will stay at a similar rate.

The second observation is that the average 30-year fixed-rate mortgage does not rise as much as the Fed Funds Rate during a rate hike cycle. As a result, mortgage rates, which are more determined by 10-year government bond yields, are also not rising as significantly.

Look at the periods between 2004 – 2007 and 2016 – 2019. The 10-year yield rose by less than half the size of the Fed Funds Rate. I am confident the same will happen again in this cycle of rate hikes.

Let’s say the Fed Funds Rate does indeed rise to 1.75% – 2% by the end of 2022. Based on history, we can expect the average 30-year fixed rate mortgage to increase by 0.75% – 1% up to 4.75% – 5%. If the Fed hikes three more times to 2.5 – 2.75% in 2023, we can expect the average 30-year fixed-rate mortgage to rise to 5% – 5.375% over two years.

Before that time, consumers have ample time to refinance. Mortgage rates will still have negative real mortgage rates for most of this time. Furthermore, wages and corporate profits will continue to grow, strengthening both consumer and corporate balance sheets.

As a result, it makes sense to buy single-family and multi-family homes. This also applies to investing in build-to-rent funds and other private real estate funds that specialize in rental properties. Half of my wealth is in real estate, in part because I believe in history.

A resilient and strong economy

The speed of change in the financial markets is increasing. Oil can rise 30% one week and collapse 30% a few weeks later, suddenly making a recession less likely. The Federal Reserve could raise 1.25% in more than five meetings to change its mind and pause because of another goddamn COVID variant.

Despite all these moving parts, all we know is that the US economy is resilient. We, the people, are also resilient. Therefore, the optimal decision is to stay invested in US stocks and real estate for the long term.

Of course, we may have a strong preference for the home country. However, I wouldn’t bet against the American people. We will find ways to adapt and meet future challenges. As a result, we will continue to grow more prosperously in the long run.

Readers, how are you changing your stock investment strategy in this Fed rate hike cycle? Do you plan to buy more stocks in technology, real estate, energy, healthcare and utilities? What about buying more physical real estate? Do you believe that the Fed will eventually succeed in raising the Fed Funds Rate to 1.75% – 2% by the end of the year and another 0.75% by the end of 2023?

Disclaimer: Do your own due diligence. Don’t invest in something you don’t understand. Your investment choices are yours alone. There are no guarantees for risky investments.

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This post How the Stock Market Has Performed During Fed Rate-Hike Cycles

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