Take a moment to imagine what the world and your business would look like if interest rates were at four per cent — or even six per cent — instead of two per cent.
Everyone has been talking about inflation and interest rates and yield curve inversions lately, so what does it all mean? While a lot has been written about the effects on the stock market when interest rates rise, what happens to commodity prices, consumer price inflation and currencies? What about the influence of higher interest rates on longer-term bond yields?
To set the stage, there have been nine periods of rising central bank rates in the U.S. since the late 1960s. They have typically lasted just over two years and increased on average five full percentage points. However, subsequent to the dramatic rise during the late 1970s and early 1980s when Paul Volcker was head of the U.S. Federal Reserve, rate increases have averaged only around 2.75 per cent. Some of these periods were as short as a year with one lasting just over four years during the height of the inflationary period from 1977 to 1981.
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We already know the history of U.S. stocks during these periods of rising rates because here’s what I wrote about stocks a couple of months ago in this column. Six months to a year after an initial rate increase, U.S. stocks have still moved up around five per cent. Furthermore, longer-term analysis shows that even during the last eight rate-rising cycles since 1970, which have typically lasted about 2-1/2 years, the broad-based U.S. stock market, as measured by the Wilshire 5000 Index, still moved up on average around seven per cent during those tightening phases. Based on past trading patterns, rising interest rates may not be as much of a concern for stocks as you think.
Now what about other areas like commodities, inflation, currencies and long-term interest rates?
During these previous rounds of rate increases, U.S. consumer price index (CPI) inflation registered at about five per cent. Considering inflation is currently running above that at around 6.5 per cent in Canada and 8.5 per cent in the U.S., we could match that historical average annual inflation rate of five per cent or even more over the next couple of years. Likewise, commodity prices rose over 15 per cent on average over the course of these rate-rise periods, or just over six per cent annualized. Of note, commodities were up almost 100 per cent from 1972 to 1981, which was greatly influenced by the 1973 oil embargo and then the 1979 Iranian Revolution. Perhaps we’re seeing echoes of this today with the Russian invasion of Ukraine and resultant economic and trade sanctions that are constricting agriculture, energy and metal commodity supplies.
As for currencies, the U.S. Dollar Index, which represents the U.S. dollar compared to a basket of other global currencies, didn’t really show any particular trends either way although it had swings of five or 10 per cent, both up and down. But this is nothing out of the ordinary compared to any random one-, two- or three-year period.
This is likewise true of the Canadian dollar versus the U.S. dollar. There was not much change most of the time, moving five per cent or less, which isn’t significant movement for a currency over a two- to four-year period. However, the Canadian dollar did have a few bigger 15 per cent moves both up and down. Overall, though, rising rates in the U.S. did not produce any specific directional trading activity for the U.S. dollar since there are just too many other outside factors that can influence the direction of global currencies.
Finally, what have longer-term rates done when short-term rates move higher? In all previous instances, 10-year U.S. Treasury bond yields did increase and did so fairly consistently, moving up around 25 per cent by the end of the cycle. So, if 10-year U.S. Treasury rates were around two per cent before the Fed started raising rates, a 25 per cent increase would bring it to 2.5 per cent. Since the yields are already almost three per cent, they could eventually reach three per cent, four per cent or maybe more, with similar levels in Canada.
Bottom line, the fluctuations of stocks, bonds, currencies and commodities during periods of rising interest rates are not always as dramatic as you might think. The main exception was the high inflationary period from 1977 to 1981 which was certainly the most disruptive of all the time periods. Historically, commodity and stock market activity were the most consistent. Both these asset classes generally moved higher during interest rate hikes while currencies had big moves both up and down.
So how will history repeat itself this time around? No one knows for sure but it will have its own unique characteristics. There are no rules when it comes to how various commodities, assets and currencies will react during each interest rate rising cycle. So much will be determined by unknown and yet-to-occur political, military, economic, monetary, social and weather events.
As always, never say never and use all the grain-marketing tools available to you, especially option hedging strategies, to capture price opportunities, manage downside risk and minimize delivery concerns.
