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This past Wednesday wasn't just the end of the second quarter, it was also the last day of a two-day Federal Reserve meeting where the policy makers raised short term interest rates for the first time in four years. What happened and where are the markets headed?
After a scorching 2003 performance, the major market averages have managed to tread water at best this year. Normally, the third year of an incumbency has the best stock market performance, but 2004 held some other clouds on the horizon, most notably the war on terror and the on-going strife in Iraq. The labor picture was murky until a few months ago and now even the Fed believes the strong growth picture, hence the ¼ percent hike in the federal funds rate. Will the market suffer in the wake of the rise in rates?
It generally takes several rate hikes to take the wind out of the market's sails. Rising rates are a sign of a strong, healthy economy. That strong economic backdrop is positive for stocks as it means people are spending and profits are rising. Taking a look at other rising rate cycles, stocks do well six to twelve months after the first rate hike. Toward the second year of rising rates, the economy starts slowing (as desired by the Fed) and the stock market pulls back in response.
This time the market may continue to hold its head above water, but different sectors and industries may take the lead. For the first half of 2004 energy, basic materials, consumer electronics and some financial stocks did well. With the move to raise rates banks and financial services firms are expected to take a hit. So are automakers and insurers. Interest rate sensitive stocks and sectors could feel the brunt of the Fed's action.
But the Fed's move had been widely anticipated. Rates are at 46-years lows and even with an upward bias, there's no reason to expect them to rocket to the stratosphere overnight. A two-percentage point increase will still place interest rates below historical averages and still appear quite attractive.
And while rising rates are an anathema to bond holders, they are welcome news to those of us sitting with money in insured bank accounts or other short-term investment vehicles. As recently as March, the rate on a one-year certificate of deposit was 1.1 percent, but in anticipation of the Fed hiking rates, the rate had increased to 1.5 percent, according to Bankrate.com. Short-term investors can "ride the escalator" of higher rates by plowing funds into successively higher-yielding securities as the lower ones mature.
Rising rates may also help pension funds close their funding gaps. Traditional pension plans are required to use long term rates to estimate their future pension payments. Pension plan under-funding has been estimated to be as large as $250 billion. A one-percent rise in rates could shrink the pension gas by about $133 billion.
The flip side to that is our budget deficit. The U.S government issues debt obligations -- Treasury bills and notes -- with interest paid to holders of our debt. As rates rise, either the price of the outstanding debt obligation must fall to make it attractive for investors to purchase and hold to maturity or we must raise rates on new debt obligations to keep those investors. The Congressional Budget Office estimates that a one percent jump in rates per year would increase our national debt by $592 billion over a decade.
So even though it looks like the party's over for some investment areas, it could just be starting for others.
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