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Fund Family Shareholder Association
Rather than waiting for the event to
happen and then reacting emotionally
or getting caught up in the headlines,
it helps to think through and prepare
for those situations we can see com-
ing down the road—even if the timing
is uncertain. One way we can do this
is by looking to history for potential
lessons and as a guide for setting
expectations.
Before we get too far ahead of our-
selves, let’s go back to square one and
make sure we are all on the same page.
The Federal Reserve, the U.S. cen-
tral bank, is tasked with a dual mandate
of trying to provide price stability and
full employment. It is also the lender
of last resort, as we saw during the
financial crisis in 2008. Let’s be clear,
though: The Fed does not control the
economy or the markets. It does, how-
ever, try to influence them, with often
mixed results.
The Fed’s primary tool of influence
is the federal funds rate, or the inter-
est rate at which banks lend money to
each other overnight. How does that
work? Well, banks take in and send
out cash throughout the course of the
day, but at the end of each day there
is a minimum amount of cash they
are required to have on hand. Some
banks will be short of this mark, and
others will have an excess of cash.
A bank that is short will borrow the
money from a bank that has a surplus.
Typically, a bank only borrows the
money for the night, because the next
day, it may take in more money than
it sends out, and would find itself in a
position to lend any excess cash. This
overnight rate is called the fed funds
rate, and it is the base rate that banks
then set other interest rates off of. It
influences what banks are willing to
pay on savings accounts and CDs, as
well as what rate they are willing lend
money at for, say, a mortgage or small
business loan.
Interest rates impact economic
activity by motivating people to either
save more or invest (spend) more.
When interest rates are low, people
are more likely to go out and borrow
money to buy a house or build a plant
or start a company. But if you can earn
a high rate of interest on a savings
account, you might be more likely to
keep your cash in the bank, earning
that high level of income, and put off
buying that house for another time. So
when the Fed wants to encourage eco-
nomic activity, it eases or lowers the
fed funds rate. Conversely, if the Fed is
looking to slow things down (or feels
that it no longer needs to encourage
more activity), it increases (tightens)
the fed funds rate.
The last time the Fed tightened was
more than eight years ago in June 2006,
when it bumped the fed funds rate up
by 0.25% to 5.25%. Since then, it’s
all been downhill. During the depths
of the financial crisis, the Fed went
to great lengths to keep the economy
from a potential collapse, and brought
the fed funds rate all the way down to
0.25%, which is, in essence, zero. As
you can see in the chart above, the fed
funds rate has been pinned there ever
since. With the end of quantitative eas-
ing in sight, investors are now looking
ahead to the next step toward a more
normal interest level—a hike in the fed
funds rate—and its impact on both the
bond and stock markets.
So, should investors like us really
fear a rising fed funds rate? First, even
a cursory glance at the chart on the left
makes it readily apparent that changes
to the fed funds rate in either direction
are nothing new. It’s actually more
unusual for the fed funds rate to be
as stagnant as it has been the past five
years. While there have been periods
when the rate was moved higher and
then lower and then higher in a fairly
rapid series of actions, I’ve highlighted
six periods starting in 1976, 1983,
1986, 1994, 1999 and 2004 when the
general trend was tightening—or high-
er fed funds rates.
For those who like to ponder the
numbers, in the table below, I’ve pro-
vided the specifics of each rising rate
cycle as well as several statistics on the
economy at the time the Fed started to
raise interest rates. A key takeaway is
that no two rate cycles are the same.
Each tightening cycle of higher rates
started and ended at different levels
and lasted varying lengths of time. In
the 1976 cycle, the fed funds rate rose
to more than four times its starting
level, while the 1999 cycle saw it rise
to just 1.4 times as high. The economic
environments that motivated the Fed to
raise interest rates were just as diverse,
with inflation ranging from 1.7% to
6.3% and unemployment ranging from
4.2% to 10.2%.
That’s the simple history. Now let’s
get to the crux of the issue—the impact
of rising rates on stocks and bonds.
Bonds Stumble, Then Step Up
Let’s start with bonds, as their per-
formance is most closely tied to chang-
es in interest rates. As we’ve seen over
RATES
FROM PAGE 1
>
A Rising Fed Funds Rate is
Nothing New
6/78
6/82
6/86
6/90
6/94
6/98
6/02
6/06
6/10
6/14
0
2
4
6
8
10
12
14
16
18
20
Rising Rate Environment
Prime Money Market SEC Yield
Fed Funds Rate
No Two Rate Hike Cycles Are the Same
Start
Date
Fed Funds
Starting
Level
Fed Funds
Ending
Level
Change in
Fed Funds
Level
Scale
of
Change
# of
Months
GDP
Growth Inflation Unemployment
Dec-76
4.75% 20.00% 15.25% 4.2x
40
4.3% 6.3%
7.8%
May-83
8.50% 11.75% 3.25% 1.4x
16
3.3% 4.1% 10.2%
Dec-86
5.88% 9.75% 3.88% 1.7x
27
2.9% 3.8%
6.9%
Feb-94
3.00% 6.00% 3.00% 2.0x
13
3.4% 2.9%
6.6%
Jun-99
4.75% 6.50% 1.75% 1.4x
12
4.8% 2.1%
4.2%
Jun-04
1.00% 5.25% 4.25% 5.3x
25
4.2% 1.7%
5.6%
Current
0.25% — — — — 1.5% 1.9%
6.1%
