It’s no secret that the Federal Reserve is almost certain to raise the federal funds rate following the March 15-16 committee meeting. The bond market has been anticipating higher rates for some time, and market interest rates have risen over the past year and a half, in part on anticipation. During the initial market rate hike that began shortly after the pandemic triggered the economic shutdown in March 2020, the yield curve began to steepen, as seen in the top panel of the chart below. below. However, since the start of 2021, the yield curve (10-year Treasury yield minus 2-year Treasury yield) has flattened, i.e., short-term interest rates have risen faster than long-term interest rates.
It is common for long-term rates to rise when the economy comes out of a recession. Stronger economic activity can lead to inflationary pressures, and investors are seeing that now. One of the reasons the Federal Reserve raises short-term interest rates is to slow down a potentially overheated economy. With a slowing economy and likely fewer headwinds from inflation, longer-term rates tend to stabilize or fall. The equilibrium for the Fed is not to drive short rates up too quickly, which would cause the yield curve to invert, i.e., short-term interest rates would rise above interest rates. long-term interest. However, history suggests that the Fed tends to go overboard in its efforts to raise rates and slow the economy with the end result of the economy falling into recession. The yellow shading on the chart below represents the times the Fed raised rates until the time of the last rate increase. The blue line represents the yield curve and it shows that in three of the last four rate hike cycles over the past 30 years the Fed has gone too far in raising short-term interest rates and the economy fell into recession.
Yield curve data going back to 1955 shows that only twice has a recession not followed an inverted yield curve. More information on this can be found in a Federal Reserve Bank of San Francisco research paper, Economic Forecasts with the Yield Curve. Highlights of this article can be read in an article I published in the summer of 2018, Respect The Predictive Power Of An Inverted Yield Curve.
For investors, certain stocks/sectors tend to do well in a rising interest rate environment. ProShares created the Equities for Rising Rates ETF (NASDAQ: EQRR) which has outperformed during this period of rising interest rates, as shown below. However, to be on the safe side, the ETF’s 50 stocks only fall into five sectors, financials, energy, materials, industrials and technology. The chart below also shows the Invesco S&P 500 Pure Value ETF (NYSEARCA:RPV) which worked almost online with EQRR. RPV is more diversified as holdings fall into all eleven GICS economic sectors, with financials, healthcare and commodities being the three largest weightings.
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