In December 2015, the Federal Reserve raised short-term interest rates by 0.25%. It was the first such interest rate increase in eight years, reversing a long trend of falling or low interest rates. In early 2016, the stock market did not take the news well. Beginning on the first trading day of the new year, the US stock market started a selloff that did not end until mid-February with the S&P 500 index down over 13% from its value at the start of the year.
This year, some analysts expected a similar result. The Federal Reserve once gain increased short-term interest by 0.25% in December, only the second such increase following the Great Recession. Yet this time the stock market not only failed to decline in the first week of January, but it actually extended its gains from December. So why the different market reaction in 2017 compared to 2016?
For a clue, we can look to the yield curve, the graphical depiction of interest rates paid on bonds of different maturities.
When short-term interest rates increase during a period of weak economic growth, longer-term interest rates often decline. This can be a sign that the economy is too weak to absorb an interest rate hike. This is what occurred in early 2016. Short-term interest rates increased from 0.25% to 0.50% while long-term interest rates fell from 2.25% in December 2015 to 1.78% by March 2016. The bond market clearly signaled an expectation that an increase in short-term interest rates would lead to slower economic growth or a recession.
The yield curve has signaled a very different expectation recently. While short-term interest rates increased, long-term interest rates also shifted upward. This is a sign that the bond market expects the economy to be able to absorb the increase in short-term rates and continue to grow. This is indicative of the late stages of the economic growth cycle in which both short-term and long-term interest rates increase in response to rising inflationary pressures. Increasing inflationary pressures and rising interest rates can coincide for some time as long as the rate of economic growth persists. However, eventually inflation often leads to interest rates that increase to a point where economic growth slows, leading to a recession.
As the famous MIT economist Rudi Dornbusch once quipped, “None of the post-war expansions died of old age. They were all mur-dered by the Fed.” Therefore, it is important to watch the shape of the yield curve during future Federal Reserve interest rate increases for signs that the economy may respond negatively to the effects of higher short-term interest rates. Until then, continued economic growth may be the most likely path forward.