Photographer: Adam Rountree/Bloomberg

History Shows ‘Slow and Steady’ Is Best Rates Mantra for Stocks

  • S&P 500 gains average 11 percent in slow rate increase cycle
  • Fed's latest meeting minutes point toward gradual approach

The stock market’s message for Janet Yellen has been that slow and steady on interest rates is preferable to fast and furious. History not only backs that up, it also shows the margin of victory can be wide.

U.S. stocks have gained an average of 11 percent over a year’s time when the Federal Reserve takes a gradual approach to raising lending rates, according to data from Ned Davis Research. That compares with a 2.7 percent average decrease during faster rate cycles.

That could be good news for equity investors over the next 12 months, as Fed Chair Yellen has stressed the central bank intends to move cautiously in implementing the first rate increases since 2006. Stocks have been whipsawed over the past several months as investors have scrutinized each clue from Fed officials on the timing and pacing of rate hikes.

“Fast sends a message to the market that we’re behind the curve. Slow just says we’re following economic conditions,” Mark Kepner, an equity trader at Themis Trading LLC in Chatham, New Jersey, said by phone. “It would be worrisome for the market to think the Fed is behind the curve with something like inflation.”

The data from Ned Davis show that there hasn’t been a “slow” cycle since the late 1970s. During a slow cycle, in which the Fed skips meetings between rate increases, the S&P 500 rises on average around 11 percent one year later. During a fast cycle, when the Fed raises rates at each meeting, the benchmark index declines a few percentage points on inflationary concerns.

The fast approach can result in a severe reaction by equities markets. In January 1973, the Fed lifted rates swiftly in the wake of an OPEC oil embargo on the U.S. The federal funds target rate was raised 15 times through August. The S&P 500 benchmark index plunged 20 percent in the 12 months following the initial rate move.

Stocks reacted better when the Fed increased rates in August 1977, moving at a gradual pace as the Paul Volcker-led committee aimed to combat inflation. The central bank left rates unchanged in November and December, and kept them steady for three months after a January increase. The S&P 500 was up 7 percent a year after the August rate hike.

The 1977 move was followed by progressively steeper rate increases that subsequently weighed on equities. The fed funds rate spiked from 10 percent in September 1980 to 20 percent by the end of the year as the economy entered a recession. The S&P 500 lost 8.6 percent over the 12 months.

Investors are betting the next rate cycle will be less volatile. Minutes of the Fed’s latest meeting released Wednesday signaled policy makers think the economy is strengthening enough to withstand higher interest rates as soon as next month, while stressing the pace of any increases will be gradual. The S&P 500 jumped 1.6 percent on the news.

Moving slowly after liftoff would give policy makers time to assess the impact of higher rates on the economy and reduce the chances they would overshoot and raise rates too high, Fed Bank of Boston President Eric Rosengren said earlier this month.

“I view the likelihood of this being a slow cycle as a marginal positive for the market,” said Liz Ann Sonders, chief investment strategist at Charles Schwab & Co. “The Fed is likely to be more methodical this time. It’s the Fed choking off liquidity historically that has led to market trouble and economic trouble. That doesn’t appear to be the case this time.”

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