Testimony by Chair Janet Yellen before the Senate Banking, Housing and Urban Affairs Committee is going to be closely watched this week. The two-day question and answer sessions may shed some light on future interest rate hikes. Fed watchers are split 50 / 50 on a possible quarter point rise in rates coming in June.
Why should Investors get nervous?
Long duration bonds will decrease the most in price in a raising rate environment. For example; The U.S. ten-year bond yield has already moved from 1.66% to 2.13%!
Dividend paying stocks in the utility and communication sectors will experience a decrease in value as investors move to the safety of short duration bonds. The chart below is the year to date price of the utility ETF (XLU)
Interest-rate Increases Have a Potential Spillover Effect
There is $9 trillion of debt owed in U.S. dollars by non-bank borrowers outside the United States. Higher borrowing costs for companies and governments, along with a stronger greenback, may add risks to an already-weak global recovery. A stronger greenback means a company or government needs even more local currency to repay debt if it lacks revenues in U.S. dollars.
Commodity prices which are denominated in U.S. dollars, have already fallen as the greenback has strengthened and demand has deteriorated. The economies of countries which rely heavily on exports of oil, iron ore, copper, gold and other commodities could slip into an economic recession. (Canada & Australia)
Mortgage rates would go up which is a drag on the housing market and will affect the stock prices of home builders and their suppliers.
Previous Cycle of Raising Interest Rates
From 2004 to 2006, the Fed raised its benchmark interest rate from 1% to 5.25%. During that stretch corporate bond yields in the U.S. surged from a than all-time low of 4.9% to as high as 6.9% in June 2006!
The S&P 500 was up 10.9% in 2004, 4.9% in 2005 and 15.9% in 2006 so raising rates are not necessarily bad for stock market returns.
I am by no means an expert but here is my 2 cents worth. I think that more data on the health of the U.S. economic is needed before a rate decision will be made. The 4th quarter growth in the U.S. was only 2.6% which isn’t exactly stellar. Consumer spending was negative for both Dec. & Jan. which could lead to weaker growth in the first quarter of 2015. The low price of cruel oil is deflationary and would get worse in an environment of raising interest rates.
The U.S. housing market hasn’t rebound enough to withstand higher mortgage rates. Housing is a big component of economic growth when you add in all the industries that rely on new housing construction. (lumber, appliances, furniture…etc). The U.S. dollar would increase in value even more which would reduce earnings of U.S. multi-national corporations and in turn would affect both job & wage growth.
If I had to guess, a small rate hike wouldn’t happen until sometime in the fall of 2015 however I do have some cash on the sidelines. The stock market could experience a 5% to 10% correction if the Fed signals this week that they will raise rates in June.