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When the Fed hikes the rates…

“Those who cannot learn from history are doomed to repeat it.” George Santayana (1863-1952). Let’s see for the past 25 years, using Morningstar data on two benchmarks, Vanguard 500 Index and Vanguard Total Bond Index for stock and bond performance for the years 1988-2013, how the rate movement impact the markets, in particular in 1994 and 2003.

Here is what happened in chronological order when the Fed’s rate moved:

1989-1993: Fed rate down 6%…bonds up 8% – The Fed began cutting the rate in 1989 from 9.25% to 3% range in 1992 and no changes in 1993. As a result, average bond fund returns were 7.1% in 1992 and 6% in 1993 while the Fed rate moved sideways in a 3% range. As for the stocks, in 1989, Bush 41’s first year, the S&P 500 rallied 31.3%.

1994: Fed rates up 3%…bonds drop 7% – The Fed began raising rates in early 1994, after holding steady at 3% throughout 1993. The rate hit 6% in early 1995. The total returns of bond market in 1994, dropped from 9.6% to –2.6%!

1995-2000: Dot.com rally…Fed rate down a bit…bonds up 8% – The dot.com bull market rally took off in 1995. The Fed halted the increases and cut the rates back slightly from 6% to 5.5% range, which held through much of the 1995-1999 bull. The Fed rate also created a favourable environment for fixed income. Initially, long bond funds returns jumped to 18%. Then from 1996 to 1998, total bond fund returns hovered in positive territory at 3.5%, 9.4% and 8.6%. During the 5-year period from 1995-99, the S&P 500 index generated annual returns of 37%, 22%, 33%, 28% and 21%. In 1999, the last year of the bull rally, 19 funds had absurd returns of 179% to 323%! Even the Long-Term Capital Management fiasco in the fall of 1998, coupled with major global economic threats in Asia and Russia, didn’t have much of a dampening effect on the madness. The Fed dropped its rate slightly from 5.5% to 4.75% during the tense days dealing with LTC. But tech-stock continued its rallies till the first quarter of 2000.

2000-2003: 30-month recession…Fed rate down 5%…bonds up 10% – In late 1998, the Fed tried to dampen the exuberance by increasing the rate from 4.75% to 6.5% in May of 2000 when the Nasdaq index peaked above 5,000. But it was too late. The market dipped into a 30-month bear recession with the terror attack took place on September 11, 2001 and thereafter the Afghan War. The Fed then introduce a string of interest cuts, dropping the rate from 6% in 2000 to 1% by June 2003. Bonds were big-time winners. During the 2000-2002 recession, bond market returns were a healthy 8%-11% while the S&P 500 dropped into negative territory for those three years: –9%, –12% and –22% before turning positive 28.5% in 2003.

2003-2007: Fed rate up 4%…bonds drop 6% – Between mid-2004 and early 2006, the Fed hike rates from 1% rate in 2003 to 5.25% and held it just below 5% till the 2008 Global Financial Crisis. Bonds generated a gain of 3% to 6% during this stock rally. For the next 4 year after it gained 28.5% in 2003, the stock market delivered 10.7%, 4.7%,15.6% and 5.4%.

2007-2008: Fed rate down 5%…bonds up 2% – Between 2007 and 2008, with the collapse of Lehman, Countrywide, AIG, Merrill Lynch, Bear Sterns and Freddie/Fannie, then the Presidential Election, the Fed dropped rate from 4.75% in September 2007 to 1% in October 2008, and again down to a quarter point in December 2008. The stock market lost over 40%; bonds hovered in the 5-6% range.

2009-2013: Fed rate zero…stocks double…30-year bond bull ends – For the past 5 years since late 2008, the Fed effectively held rates at 0%. The stock market was bad from late 2007 to early 2009 with the Dow Industrials Index falling from a record 14,164 in October 2007 to 6,507 on March 2009. Thereafter, the market charge into a new bull. Dow Industrials Index had hit a new record of 15,658 in early August 2013. Between 2009 through 2012, bonds generated a gain of 5.9%, 6.4%, 7.5% and 4.6%. However, since late 2012, bond returns have dropped more than 6% to a negative 3%, despite the Fed rate remained unchanged. May 22, 2013 probably marked then end of a 30-year bond bull when the Fed hinted on a tapering.

Reference

MarketWatch, Paul B. Farrell, 2013-09-11, “Why Bill Gross is doomed to lose money but not you”

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