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What Happens When Interest Rates Normalize?

  • We believe the period of low interest rates is nearing an end, with a significant impact on stocks that could prove painful.  The average correction in stocks from such an event is greater than 20% and the decline is rapid, lasting an average of only 10 months – see table below.

 

 

Old Cycle End Date

Through  Date

Maximum Decline

Duration of Decline

Cycle I

12/31/1899

9/24/1900

-22.3%

9 Months

Cycle II

6/30/1920

8/24/1921

-29.6%

14 Months

Cycle III

10/31/1941

4/28/1942

-21.4%

6 Months

Cycle IV

9/30/1981

8/12/1982

-11.8%

10.5 Months

 

 

 

 

 

 

 

Mean

-21.3%

9.9 Months

 

  • Early indicators of a move to a higher interest rate environment include:

1.      Poor relative performance of consumer discretionary stocks (for example: Home Depot, McDonalds, and Target)

2.      High-quality corporate bond yields would increase first, followed by an increase in lower-quality “junk” bond yields

3.      Material weakness in the U.S. Dollar

4.      A rise in general inflation expectations

  • When the interest rate shock materializes, cash will be the most likely destination for the proceeds of bonds being sold.  Following a probable correction period in equities, a rotation into U.S. stocks will likely occur.  Stocks should perform well after the adjustment to this new direction in interest rates.
  • The consensus view of fixed income managers is rates will not rise until 2015, at the earliest, based on the Federal Reserve’s public announcements.  However, the mere expectation of rates moving higher may be all that is needed to impact stocks.  Central banks have control over short-term interest rates but only influence over long-term interest rates.  While this influence is considerable, it is not control.   A rise in inflation expectations would restrict the Fed’s ability to continue its current policies.
  • The timing of interest rate normalization after a three-decade decline is uncertain.  It is vital that we track the early indicators while we continue to participate in the current market environment.

 

(Source: BCA Research, http://bcaresearch.com, 2013)

 

By: Jordan Janes On Tuesday, 09 April 2013 Comment Comments( 0 ) Hits Views(149746)
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