The Fed's Rate Hike Is Upon Us: Here's What It Means for Stocks

Fed week is here, and it's a big one! U.S. stocks are lower in early afternoon trading on Monday, with the Dow Jones Industrial Average (^DJI -1.26%) and the S&P 500 (^GSPC -0.76%) down 0.11% and 0.35%, respectively, at 12:10 p.m. EST. It appears junk bonds may be an early casualty -- it shouldn't be a surprise -- of an imminent rate hike.

Source: DonkeyHotey. Republished under CC BY 2.0.

After falling to its lowest level since 2009, the largest junk bond ETF, the iShares iBoxx High Yield Corporate Bond Fund ETF, continues to fall today, down 0.89% (the same is true of its nearest competitor, the SPDR Barclays High Yield Bond ETF).

The catalyst for the sell-off was ostensibly Third Avenue Management's decision to halt withdrawals from its Focused Credit Fund in a chilling reminder of BNP Paribas' August 2007 decision to do the same thing with three of its credit funds because of "the complete evaporation of liquidity in certain market segments of the U.S. securitization market" (the event that kicked off the credit crisis). The fact that Third Avenue's move occurred a few days prior to the Federal Reserve's decision does not look like coincidence.

Barring a recovery in the second half of December, 2015 will see its first negative return for junk bonds in a non-recessionary year in more than three decades (since 1983, if you're wondering), according to the good people at Goldman Sachs.

But what about stocks? The typical approach in this situation is to try to glean some insights from the historical record. The table below shows returns for the S&P 500, following the start of the past three rising interest rate cycles. Note that my starting values are the closing values on the day just prior to the announcement of the Fed's decision; as you can see from the second column, the one-day effect appears to be significant.

Source: Author's calculations based on data from Bloomberg.

No clear pattern emerges, which is not entirely surprising, given the size of the sample -- just three data points. Nevertheless, none of these results are horrifying (if you can't suffer an 8% market-to-market loss on your equity portfolio with equanimity, you probably shouldn't be investing in stocks at all).

Going further back, in a 2013 report, Deutsche Bank took a look at the 12-month performance of the S&P 500 associated with all 15 of the rate tightening cycles since 1965.

In the 12 cycles that preceded the three highlighted above, the median 12-month return was 4.8% (average: 0.4%), with three losses greater than 10%, and two gains above 10%.

(I don't agree with Deutsche's methodology -- it calculated returns starting with closing values following the announcement of the decision. It's also worth noting that, prior to 1982, the Federal Reserve did not target the federal funds rate.)

Keep calm, and keep investing. For long-term investors, the Fed's decision to begin normalizing ought to be seen as a positive step toward an environment in which corporate fundamentals reassert themselves as the primary driver of stock prices.