History Shows Rising Rate Cycle is Bullish for Economy and Stocks

The market appears to be rethinking its little dose of enthusiasm following the Fed’s interest rate rise yesterday. The Dow was off around 1% while commodity prices were under pressure from a strong dollar.

It’s only a day, but it gives you an idea of the delicacy of raising interest rates after 10 years of loose money, with around half of that time involving the monetary pleasure of quantitative easing.

You see, the Fed is no ordinary central bank. It controls the world’s reserve currency. When it opens the monetary floodgates, speculative capital flows out to the rest of the world. It buys up emerging market currencies and debt, commodities and precious metals.

Now, the Fed is trying to ever so delicately unwind that trade. As long as the adjustment is slow, as in glacially slow, they may be able to pull it off. But if they go too hard, it could all unravel and we’ll be back on an easing path before you know it.

How will you know if they go too far, too fast?

This is the big question, isn’t it?

The last few crises were pretty easy to spot. The tech bubble was obvious. But it was so infectious everyone wanted to pretend that it really was different.

The subprime bubble was nothing more than glaring. There were so many clues in the lead up to it that it beggars belief that so many professionals were caught out.

But that’s the nature of bubbles, isn’t it?

Does that mean what seems confusing today will in hindsight seem obvious? Probably. But having said that, there are no blatant bubble signs. I mean, commodities are going through a bust right now. Mining stocks are off anywhere from 50% to 90% off their highs.

Oil is at its lowest point since the dark days of 2009. China is trying to slow gracefully. Emerging markets are slowly deflating too.

True, stock markets in the developed world are expensive, but when you compare them to what’s on offer in the world of bonds, they’re not THAT expensive.

Which suggests the real bubble is in global bond markets. This is what makes the Fed’s interest rate path so important.

Check out the chart below. It shows the Fed Funds rate going back to the 1950s. The shaded areas indicate a recession.

Source: Board of Governors of the Federal Reserve System (US)

What do you see here? What is the common development that preceded every single recession since the 1950s?

That’s right, it was the Fed raising interest rates.

But, and it’s a big but…

The start of the rate rising cycle was generally bullish for the economy and stocks. As you can see, when interest rates began to rise (generally some time after the prior recession) they rose for a few years at least.

There is no instance of small initial rate rises leading to a recession. It was only after a few years — when inflation presumably picked up — that the Fed keep raising rates. Leading to the next recession.

As the chart shows, the last recession was in 2008/09. It was a big one by historical standards. But what makes it unique from a post war perspective is the length of time that the Fed held rates low after the recession had passed.

In fact, rates have been on hold for roughly the whole length of previous expansion cycles. Given we are already well into an expansion cycle now, this suggests that it might not take much in the way of monetary tightening to set off the next recession.

And don’t forget, monetary tightening can happen in two ways, through rising interest rates, or via deflation. Deflation lowers the real price level, which in turn increases the real interest rate (the real rate is the nominal rate minus inflation).

Muddying the waters even more, the world is going through a period of ‘good’ deflation driven by technological advancement. This is where new technologies drive productivity gains and lower costs.

This type of deflation is great because it increases real wages and makes us more prosperous. But central banks can’t tell the difference between good and bad deflation and so they respond to the price declines with a blast of monetary stimulus.

This famously happened in the 1920s. New technologies at the time lowered the general price level, creating general prosperity. The Fed fought the deflation with easy money and blew the biggest bubble in US stock market history.

A similar dynamic is playing out today. Inflation is nowhere to be seen. That’s partly because of the huge amount of debt in the world. That debt represents future demand brought forward. The future is now, hence the absence of strong demand and inflationary pressures.

The absence of inflation is also because of technological innovation. Combining these two forces gives you deflationary pressures and central banks willing to keep rates lower for much longer than that would have in the past.

The result is a bubble in the bond markets, and a global economy very sensitive to interest rate rises.

The chart above shows that the history of past interest rate rising cycles is bullish for growth and bullish for markets. At least in the early phases of the rising cycle.

But given the extraordinary circumstances we are in, you have to ask, is this time different?


Greg Canavan,

For Markets and Money

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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