A Lesson from 10 Years Ago

Job growth is starting to pick up, and the market is bracing for a rate hike. S&P thinks investors can learn something from 1994

By Joseph Lisanti

With earnings season over, the markets seem largely focused on interest rates. Most observers now expect the Federal Reserve to raise the fed funds rate by 25 basis points (one quarter of a percentage point) in June.

The case for a rate hike in June has been reinforced by recent economic data, including the strong job growth posted in March and April. David Wyss, Standard & Poor's chief economist, points out that, by its June meeting, the Fed will also have employment numbers for May. If the data show continued strength, Wyss thinks the Fed will be confident enough to begin raising rates.

The current situation reminds us of 1994, when the Fed began a major tightening in February. Then, as now, the economic recovery had been gaining steam for a while, but jobs had yet to reflect this improvement. Immediately after the first rate hike, the stock market declined 9%. However, it began recovering two months later.

By the following February, the Fed had boosted short-term rates from 3% to 6%. The fallout from this sharp rise continued for years, and it was partially blamed for the Russian default, the collapse of Long-Term Capital Management, and the Asian debt crisis.

We think the Fed will take a more measured approach to its next round of increases.

Wyss looks for rates to rise to 4% over the next two years. The hope is that a longer period will give institutions and investors more time to adjust their portfolios. Some of this activity has been evident over the past few weeks, though a few traders will always wait until the last minute.

While the market seems to be pricing in a rise in rates, additional weakness after the first announcement is possible. However, as in 1994, the downturn is not likely to last long, and we continue to recommend keeping a majority of your investment assets in stocks.

Lisanti is editor of Standard & Poor's weekly investing newsletter, The Outlook