As we prepare for a year of interest rate hikes, certain investors may get more opportunities to enhance their after-tax returns. We explore the upside of possible volatility.
In a long-awaited move, the Federal Open Market Committee (FOMC) raised interest rates by a quarter of a percentage point at its March meeting. This was the first rate hike of several more expected this year, and it comes amid the highest inflationary environment we’ve seen in decades. In terms of expectations, the FOMC assessed the appropriate monetary policy at that meeting to be a target level of 1.875% by the end of 2022, reflecting an increase of another 1.5%. At the same time, the federal funds futures market implied a year-end rate of 2.5%. All signs point to higher rates, but the extent of the total hike is fairly uncertain.
As we exit a period of easy monetary policy and enter a new tightening cycle, it’s worthwhile gauging how a shift in monetary policy could impact the stock market going forward. The link between interest rates and stock market returns is well known, but it’s less clear how rates affect market volatility. While volatility spooks many investors, it can provide the opportunity to harvest tax losses and add value to total returns for investors in tax-managed separately managed accounts.
A quick primer on monetary policy
The FOMC is the governing body of the Federal Reserve, whose dual mandate is to promote maximum employment and maintain stable prices. The FOMC’s primary method of conducting monetary policy is by setting a target federal funds rate (FFR), the interest rate at which commercial banks lend their excess reserves to each other overnight. The FFR target is set at a level the FOMC deems appropriate to meet its dual mandate, and it’s the basis for almost all US interest rates.
Because interest rates affect company valuations and economic growth, stocks tend to be sensitive to monetary policy. When the FOMC last raised rates in December 2018, the S&P 500® fell more than 9% for the month, with investor fears of an overly restrictive monetary policy dominating the financial headlines. Since the FOMC cut rates to zero in March 2020, the S&P 500® has risen 90% during two years of accommodative monetary policy.
Given that an interest rate is the cost of borrowing, and the cost of borrowing affects how much credit business and consumers can afford, interest rates have a direct impact on economic activity. Low interest rates make credit cheaper, so the FOMC tends to lower the FFR to promote employment and stimulate spending. On the other hand, high interest rates make credit more expensive, so the FOMC tends to raise the FFR to slow the economy down.
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Why should investors care about volatility?
Cross-sectional volatility (CSV) is the standard deviation of a set of asset-weighted security returns over a period of time. This dispersion measure is typically used in reference to an index. The higher the CSV, the greater the dispersion of individual security returns within the index; the lower the CSV, the more those securities move in sync with one another. This is in contrast to an index’s standard deviation, which measures the dispersion of the index’s returns rather than the dispersion of its constituents’ returns.
In the direct indexing space, CSV can represent increased opportunities for tax-loss harvesting. Investors can harvest losses directly from individual securities within their portfolios. The higher the CSV, the more meaningful the portion of the index’s securities that experienced deep losses that, once harvested, translate to higher after-tax returns.
How are monetary policy and market volatility related?
Looking at the past 25 years of monetary policy, we can gauge how different interest rate regimes have affected CSV. We define monetary easing as any period between cyclical peaks and troughs in the FFR, while we define monetary tightening as any period between troughs and peaks.
Monetary policy and US large-cap equity cross-sectional volatility, 1997–2021
Sources: Federal Reserve of St. Louis, Parametric, 1/1/2022. For illustrative purposes only. Not a recommendation to buy or sell any security.
The pattern here may not be immediately apparent. In fact, the correlation between the two monthly time series is 0.41, a positive relationship that most observers would consider moderate. We found average CSV is a bit higher during periods of monetary policy easing, but not by much: 24.5% vs. 23.5%. That effect likely captures the tendency of the FOMC to ease monetary policy rather quickly in response to economic uncertainty, the COVID-19 pandemic and the 2008 global financial crisis being the two most recent examples.
Although CSV during tightening periods is slightly lower on average, it tends to have higher spikes. Moreover, tightening periods tend to last about half as long as easing periods. Even though there are roughly the same number of CSV spikes in both regimes, the spikes during a tightening period not only tend to be higher, but they also occur within a much more condensed period of time.
Other than the higher and more frequent CSV spikes during tightening periods, the data across the two regimes is remarkably similar. However, you might notice that CSV spikes tend to cluster during periods of transition from easing to tightening or vice versa. This is why we looked at these transitions in the six-month windows before and after tightening and easing periods begin. Consistent with the notion that the FOMC will tend to initiate easy monetary policy in periods of economic uncertainty, those six-month windows tend to exhibit higher and more dispersed CSV that spikes to higher levels.
The bottom line
Nobody can predict when high CSV will present loss-harvesting opportunities, so there’s no bad time to incept a tax-managed direct indexing account. If past is prologue, then the best time to incept is during a transition from tight to easy monetary policy, although that presumes an element of market timing. Outside of transition periods, the CSV between the two regimes offers similar loss-harvesting opportunities, with tightening periods presenting more frequent cases of extreme CSV.
