What if the Fed Raises Interest Rates? Stay Diversified

The Federal Reserve has shown increasing signs that it may begin raising short-term interest rates in December for the first time in nearly a decade.¹ And while the prospect for higher rates may be good news for savers because yields on short-term investments should rise, it has also led to some anxiety among investors about the potential implications for their longer-term investments. So how have markets reacted to rising interest rate environments historically?

An interest rate hike signals increasing economic confidence

First, it's important to recognize that the Fed is inching closer to a rate increase because the U.S. economy has been strengthening. While economic growth since the financial crisis has been relatively moderate compared with historical recoveries, the Fed projects solid annual gross domestic product (GDP) growth of approximately 2% through at least 2018. Inflation remains tame and unemployment has been cut in half over the past six years to 5.0% as of October 2015, the lowest level since April 2008 and a level that the Fed has historically considered consistent with full employment.

Second, when the Fed does move, it will be raising rates from exceptionally low levels, having held the federal funds target rate near 0% since December 2008. And while the timing of a rate hike remains uncertain, the pace of increases is expected to be relatively slow once the Fed does start moving. Slow Fed tightening cycles have historically been more supportive of financial markets than cycles in which the Fed was raising rates rapidly.

Fed rate hikes have historically led to short-term volatility but longer-term positive returns

Although financial markets have tended to respond to initial Fed moves with some volatility in the short term as investors adjust to the effects of higher rates, they have historically delivered positive returns over the following months.

As illustrated in Figure 1, U.S. stocks have on average seen strong returns in the one-year and six-month periods ahead of the first Fed rate hike during rising rate cycles over the past 20 years. Returns have been weakest in the three months before and after the first rate hike, followed by positive returns over the subsequent six-month and one-year periods.

Figure 1 also illustrates the potential benefits of the type of global diversification used in Schwab Intelligent Portfolios to help temper volatility and attempt to smooth returns over time. As shown in the chart, a hypothetical diversified portfolio consisting of not just U.S. stocks but also international stocks, various fixed income investments, gold and cash held up better during the weakest period—the three months following the first rate increase—and performed slightly better than the all-stock portfolio during the subsequent six-month and one-year periods.

Astute readers might observe that the all-stock portfolio outperformed the diversified portfolio over each period leading up to the first rate increase. Ahead of a rate hike, investor anticipation of higher interest rates can lead to a strengthening dollar and higher bond yields, potentially pressuring international investments and fixed income. This has occurred in 2015 as well, as U.S. stocks have outperformed many other asset classes in recent months.² However, as noted previously, the diversified portfolio has historically performed better following the first rate hike.

Sticking with your investment plan is important to long-term investment success

History does not repeat itself, but it often rhymes, as noted in a quote often attributed to Mark Twain. A Fed interest rate increase is not something investors should fear, as it can signal increasing confidence in the strength of the U.S. economy. While financial markets may experience some volatility in the near term, history shows that investors who have maintained a disciplined investment strategy using a well-diversified portfolio based on their long-term objectives and risk tolerance have had the best chance of successfully meeting their investment goals over time.

By David Koenig, CFA, FRM, Chief Investment Strategist, Schwab Wealth Investment Advisory

1. The Federal Reserve controls short-term interest rates by setting a target for the federal funds rate that depository institutions use to lend balances at the Federal Reserve to each other overnight. Changes in the federal funds rate can have an indirect effect on longer-term interest rates; however, longer-term rates are determined by market participants and are influenced by many factors.

2. Morningstar Direct, as of November 30, 2015.