Why Stocks Won’t Rally When Interest Rates Stop Rising

Depending on who you listen to, and who you believe, this week’s interest rate hike by the Fed could either be the last or second last in the current round of Fed tightening. Some expect no rate increase when the Fed meets in March under the new Chairman, while others expect one last increase of another quarter point.

Regardless of the outcome, investors should not celebrate the end to the current round of interest rate hikes too much. According to a recent research report done for USA Today by Ned Davis Research, since 1929 stocks tend to be down 71% of the time six months after the Fed stops raising rates. On average, stocks are down about 5 percent six months after interest rates stop rising.

While many investors would expect the opposite–they think stocks would rise if rates stop rising–the same investors neglect the fact that the effects of higher interest rates are not felt by companies and the economy until up to a year after rates rise. Higher rates obviously lead to higher borrowing costs for companies and those higher costs are not reflected in reported income immediately. There’s a time delay between higher interest rates happening and corporate earnings reflecting the increase.

Personally, I feel that the investors have not fully understood the effects of the Fed raising rates so aggressively (we are talking 14 consecutive times in a row), from a low of 1 percent to a high of 4.5 percent. The bottom line is that rates have risen 350% in less than two years. That’s got to hurt.

What was the effect on the economy and consumers when interest fell to 1 percent in mid-2004? Real estate boomed because investors and consumers borrowed aggressively to buy property. Notice though, how the Dow Jones Industrial Average never rallied to a new record high despite the 46-low rates. The Dow didn’t rally because the stock market is a leading indicator– the market knew consumers would have to deal with the harsh realty of paying higher interest costs for their purchases down the road. And, on the topic of the market being a leading indicator, the majority of stocks have already discounted the fact that the Fed’s current round of rate hikes was coming to an end.

NEWSFLASH-Preliminary figures indicate China’s economy may have passed that of France, Italy, and Britain in 2005 to become the world’s fourth largest economy. My interpretation: If China keeps on its fast-growth path, deflation will become a serious problem for the United States. The U.S. dollar will also continue to be under severe price pressure.