Higher Rates Will Hurt Stocks More Thank You Think - Part 2

In my previous week’s commentary, I explained why higher interest rates will hurt stock assets more than many might think. Naysayers pointed to the fact that rate levels are still quite low on a historical basis. Unfortunately, these folks are neglecting to place their comprehension of borrowing costs in context.

Take a look at the last 20 years of U.S. monetary policy via the Federal Funds Rate (FFR). The Federal Reserve’s tightening phase from the 4% level up to the 6.5% level pricked the tech bubble in 2000. In turn, dramatic stock losses alongside dot-com pandemonium led to massive layoffs across the corporate landscape. The 2001 recession followed.

The Federal Reserve’s response to the 2001 recession was to lower the FFR more than 500 basis points. Committee members then kept the overnight lending rate too low for too long, encouraging an environment that matched irresponsible borrowers with unscrupulous lenders.

What happened next? The housing balloon burst, stocks cratered, subprime mortgages ravaged the financial system, millions lost their jobs and the Great Recession slammed the economy.

As if “too-low for-too-long” wasn’t bad enough, the Fed double-downed on economic stimulus. Leaders dropped the FFR more than 500 basis ponts once again. They also incorporated emergency measures (a.k.a. “quantitative easing” and “QE”), keeping them in place for six years alongside zero percent rate policy. Only recently did they begin attempting to remove ultra-easy accommodation.

The implications are threefold:

(1) With interest rates, relativity matters. Ever-lower borrowing costs correspond to the amount of total debt that must be serviced. For example, when keeping asset appreciation (or depreciation) constant, a 4% mortgage (2010s) for a primary residence that goes along with 17% mortgage debt servicing is inferior to a 10% mortgage (1980s) for a primary residence that goes along with 12% mortgage debt servicing.