On Tuesday and Wednesday this week, the Fed FOMC meeting will result in a potentially historic decision to raise interest rates by 25 basis points. That the markets have already factored in a rate hike is well known. This is seen across the board in indices, equities, commodities and currency pairs. The issue is how much more of an impact will the actual decision have on financial assets? As it stands, the short-term borrowing rate set by the Fed is just 0.25%. At that level, the monetary authorities have very little wiggle room to move to facilitate quantitative easing.
The U.S. government is in debt to the tune of almost $19 trillion and rising. If the economy finds itself in the unenviable position of defaulting on its payments, or the economy takes a hit in the form of another recession, the Fed must have room for a downward revision of interest rates. In other words, this self-fulfilling prophecy of expectation naturally lends itself to a raising of the interest rates before the future downward adjustment thereof. Back in 2006, the Fed began revising interest rates lower, and they have consistently moved lower to a point where they are just above zero. Now that the Fed believes the U.S. economy has improved sufficiently to warrant a rate hike, it’s all but a done deal.
Why does an interest-rate hike matter to the consumer and the economy?
Simply put, interest rates are the additional costs levied on borrowed money. This is an important monetary policy mechanism used to control the money supply and to account for inflationary targets. We already know that the Fed has a 2% inflation target in mind. The U.S. economy is approaching the benchmark, but it is not quite there yet. The unemployment rate has declined from 5.1% to 5% – just 0.1% above the Fed's target level.
Other important criteria have also been met by the U.S. economy, notably manufacturing PMI, services PMI, consumer confidence, business confidence and nonfarm payrolls data. In fact, the U.S. economy has added millions of jobs since the recession making the case for a rate hike that much more believable. The average consumers may see a rate hike as nothing more than the government’s way to extract more money from them. In a sense, this is true but only if you are financing on credit. If however you have personal disposable income that you wish to invest in a fixed interest-bearing account, a savings account or Treasury notes, etc., a rate hike is good news. It means that your money will not be losing value in real terms. U.S. savings accounts have paid virtually nothing on deposits, and this has dissuaded savings to a degree.
U.S. equities markets decline following rate hikes
The issue is altogether different when it comes to equities and the economy at large. For starters, equities markets like the Dow Jones Industrial Average, the NASDAQ, the FTSE 100, the CAC 40 and the DAX will not typically react well to a rise in interest rates. There are several reasons for this, notably the higher cost of credit. As companies that are listed on stock exchanges typically borrow huge sums of money from banks at preferential rates, any increase in interest rates will naturally impact on the bottom line. This is something that companies and their investors eschew. Dividends tend to be lower and stock prices tend to plummet when interest rates rise. There is also the issue of import and export potential. When interest rates rise, the U.S. dollar strengthens, and when the U.S. dollar strengthens, exports from the U.S. to foreign countries declines. It is a complex process, but it is a well-known fact that U.S. equities markets have historically declined for a period of six months following a rate hike.
But it is not only equities markets that turn bearish when rates are raised; it's commodities, too. Since many commodities are dollar-denominated, like gold, crude oil and the like, any appreciation of the U.S. dollar naturally leads to a decline in the demand for dollar-priced commodities. If you are wondering whether stocks will become persona non grata after the rate hike, don't get lost in the weeds. Equities will continue to be a viable investment opportunity since the fundamentals of the U.S. stock market are sound. Sure we will see some seesawing activity in the price of equities, but the important thing to bear in mind is that the hike will be gradual. Economic analysts at Banc De Binary expect the Fed interest rate to be 1% by the end of 2016 – that is 0.75% higher than the current rate.
Goldcorp Inc. is a strong sell
Homeowners will not be happy about the rate hike since it will mean that the costs of mortgages will likely increase once the lag effect has been factored in. But almost everybody is more concerned about falling prices as a result of weak demand from China and its concomitant effect on commodities from developing countries around the world. In this vein, there are several stocks that you should avoid after the rate hike, and these are directly related to gold, such as Goldcorp (GG, Financial) which is currently trading at $11.09 (-7.66%) on the New York Stock Exchange.
This is just one example of many stocks related to the mining industry that will not fare well when interest rates rise. Since gold is primarily the go-to investment option for times of geopolitical uncertainty or stock market weakness, you may be forgiven for thinking that now is the time to buy gold. However the demand for gold typically moves in the opposite direction to the strength of the U.S. dollar. A rate hike will result in a strengthening of the U.S. dollar, if only marginally, and this will have an adverse effect on gold demand, leading to a decline in the price for gold stocks. All the short-term indicators for Goldcorp point to a 100% sell – regardless of which way you cut it.
When it comes to making decisions about which stocks to buy and sell because of a rate hike, it's important to factor in the size of the rate hike and the frequency of potential future rate hikes. If the Fed takes the approach that the rate hike is a once off affair, we will likely not see too much negativity in the equities markets. It also depends on your age as an investor: older investors don't have much time to generate yields, while younger investors tend to go with long-term stock investments because they have time to play with. Therefore, your risk appetite is greater when you're younger, and less when you're older. Capital preservation seems to be the order of the day for older investors, and they would prefer stable dividends from strong companies like Pfizer (PFE, Financial), Procter & Gamble (PG, Financial) and Kellogg (K, Financial). If you're looking for yield, you may wish to consider those emerging market bond funds that tend to feature oversized returns. But a caveat is in order: if bond markets generate strong yields after interest rates have risen, this could prove negative for other high yield options.
