Impact of Raising Interest Rates On Stock Performance

When the Federal Reserve (Fed) raises interest rates, it impacts many parts of the economy, including the stock market.  Shrinking the money supply helps to keep the lid on inflation, a primary concern of the Fed. It also makes it more expensive to borrow money, causing consumers and businesses to cut back on spending. This, in turn, can lead to a reduction in the valuation of companies and their stocks as their cost of doing business goes up while profits decline.

Taken together, these factors can make the stock market less attractive to investors. So when the Fed raises interest rates, most investors expect stock prices to decline. However, historical data shows a decline in stock prices during rate hike cycles to be the exception rather than the rule. In most cases both stocks and bonds perform well during the year leading up to a rate hike cycle and the year after.

The following study looks at six rate hike cycles between 1983 and 2004. In only a few cases did S&P 500 index returns show a decline in performance. Moreover, when measured 500 days after the first rate hike, index returns during this 21-year time period averaged more than 14%.

impact of raising interest rates

Share this Image On Your Site

S&P 500 Index Returns Before and After Rate Increases

Date of 1st Rate Hike 250 Days Before 250 Days After 500 Days After
May 1983 36.60% -1.10% 12.20%
Dec 1986 19.10% -5.90% 11.20%
Mar 1989 -11.40% 11.70% 30.60%
Feb 1994 5.30% .060% 34.10%
Jun 1999 19.70% 6.00% -10.70%
Jun 2004 14.80% 4.40% 9.10%
Average 14.00% 2.60% 14.40%

Although equities typically perform well before and after interest rate hikes, they usually experience increased volatility. Also, periods of consolidation frequently accompany the beginning of rate hike cycles. Therefore, when making investment decisions before and after an interest rate increase, historical rates of return should not be the only decision criterion under consideration.

Bond Performance

Although not quite as strong as the stock market, U.S. bonds (as measured by the Barclays Aggregate Bond Index) also performed surprisingly well both before and after an interest rate hike. Average returns were slightly higher during the 12 months after a rate hike cycle than in the 12 months before the start of the cycle, with both outpacing average bond returns during all time periods.

Time period                                                             Average total return

12 months before the first hike of a cycle                                      10%

12 months after the cycle ends                                                      11.4%

Average for all time periods                                                         7.32%

To understand the true value of how bonds perform over time, the compound annual growth rate (CAGR) offers a useful tool. The CAGR is a mathematical formula that indicates what an investment yields on an annually compounded basis at the end of a defined investment period. In the case of bonds, it measures the annual return after adjusting for inflation. As we can see, 5-year treasury notes yield a significantly higher CAGR than long-term treasury bonds.

Compound annual growth rate (CAGR) for bonds during the last eight rate hike cycles:

5-year Treasury notes – 2.6%

Long-term Treasury bonds – 0.3%

Overall average – 2.5%

Comparative Performance During Rising Interest Rate Cycles

Which type of investment offers the best returns before and after rate cycles? In a study comparing the S&P 500, Barclay’s Aggregate Bond Index, long-term government bonds and a diversified portfolio, the S&P 500 led in average returns both one year before and one year after the rate hike.

The S&P 500 also had the highest average 12-month rolling return. However, a diversified portfolio came out ahead in the weighted CAGR category, barely topping the S&P 500 by less than one percent. Interestingly, global equity prices also trended upward before and after interest rate hikes, and declined during the rate hike cycle.

S&P 500

Return one year before rate hike              18.0%

Return one year after rate hike                 14.6%

Weighted CAGR during rate hike               8.0%

Average 12-month rolling return               12.5%

Barclay’s Aggregate Bond Index

Return one year before rate hike              10.0%

Return one year after rate hike                 11.4%

Weighted CAGR during rate hike               2.6%

Average 12-month rolling return                 7.3%

Long-Term Government Bonds

Return one year before rate hike              11.5%

Return one year after rate hike                 12.6%

Weighted CAGR during rate hike               0.8%

Average 12-month rolling return                 8.8%

Diversified Portfolio

Return one year before rate hike              15.0%

Return one year after rate hike                 13.8%

Weighted CAGR during rate hike               8.7%

Average 12-month rolling return                 9.5%

 Global Equity Prices

During the run-up to rising interest rate cycles

During the rising rate cycles ↓

After the rising interest rate cycles ↑

Market Sector Performance Relative to the S&P 500

During rising interest rate cycles, deep cyclical market sectors (companies whose earnings and revenues are significantly impacted by the economic cycle) outperformed the S&P 500, while defensive sectors (companies that produce goods and services people need irrespective of economic conditions) underperformed.

% over- or underperformed during the last seven interest rate tightening cycles:

Energy:                                    +8.5%

Materials:                               +6.2%

Industrials:                             +5.5%

Technology:                            +3.5%

Consumer Discretionary:       +3%

Healthcare:                             +1.3%

Consumer Staples:                 +.8%

Financials:                                -.5%

Utilities:                                 – 2.5%

Telecom Services:                 -3.4%

Real Stock Returns by Decade After Inflation

The true measure of stock performance is determined by the real return, which subtracts the inflation rate from the return rate.

Return Rate | S&P 500                         Inflation              Adjusted Return
1950’s: 21%                                                  2%                                          +19
1960s: 8.7%                                                  2.4%                                       +6.3
1970s: 6.2%                                                  6.1%                                       +.1
1980s: 18%                                                   5.2%                                       +12.8
1990s: 19.1%                                               3.9%                                       +15.2
2000s: 1.2%                                                  3%                                         -1.8
2010 –13.4%                                                 2.5%                                       +10.9

In general, stocks performed better during periods of declining rates, but returns during periods of rising rates were also attractive. The worst period for real returns occurred during the 2000’s, when rates were declining.

1947 to 1981 – 33 years of rising interest rates

Average return after inflation: 6.95%

1982 to 2016 – 35 years of declining interest rates

Average return after inflation: 8.74 %

In general, stocks performed better during periods of declining rates, but returns during periods of rising rates were also attractive. The worst period for real returns occurred during the 2000’s, when rates were declining.

Key point: It is very difficult to predict stock performance based on rising or falling interest rates.

Keep in mind that interest rates are only one of many different factors that determine the price and performance of stocks. Moreover, these factors can interact with each other in many different and unpredictable ways. While historical data shows that stocks generally do well before and after a rate hike cycle, smart investors take into account all factors when making investment decisions.

About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.