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.