Investors have long anticipated the moment when the Federal Reserve (Fed) will increase interest rates—and they are still waiting. The soft tone to U.S. first-quarter economic data coupled with below-target inflation has provided the Federal Reserve with considerable latitude as to when to start raising short-term interest rates. Still, given that the United States is creating jobs at the fastest pace since the late 1990s and the risks that ultralow rates pose to financial stability, it is increasingly difficult to justify a 0% policy rate. As such, while the pace of monetary tightening is likely to be gradual, the Fed should start to remove monetary accommodation later this year. The question then is: What will be the impact of the Fed moves, particularly for equities?

In answering that question, it is important to first note that this will be a very different tightening cycle compared to previous instances. The Federal Funds rate has been at 0% for nearly a decade. After several rounds of quantitative easing, the Fed’s balance sheet stands at approximately $4.5 trillion, more than five times its pre-crisis level. The flip side of a swollen balance sheet is substantial excess reserves in the banking sector. This scenario will require the Fed to adopt a new set of monetary tools, including interest paid on excess reserves (IOER) and reverse repurchase agreements. Given these differences, the equity market’s reaction to tightening is more unpredictable than previous cycles. That said, history does suggest that the switch from ultra-loose monetary accommodation to tightening, albeit gentle tightening, is likely to have an impact.

The start of a tightening cycle typically causes some rise in volatility, but rarely a bear market. The extent of the impact is likely to be influenced by two other conditions: changes in equity valuations and the direction of inflation. The fact that U.S. equity multiples have been rising suggests that markets are at greater risk for at least a modest correction, say, 5% to 10%. One area in particular warrants caution: small caps, which investors have embraced as a way to mitigate the impact of a strong dollar on earnings. Historically, however, small caps have been more sensitive to monetary tightening than large caps. The good news is that to the extent short-term rates are rising in conjunction with inflation—so real rates are flat—this should mitigate the impact from a Fed lift-off.

 

Get full report

Investment Directions

In-depth market commentary, analysis and actionable investment ideas from BlackRock’s leading strategists.

This paper is part of a series prepared by the BlackRock Investment Institute and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of January 2015 and may change as subsequent conditions vary. The information and opinions contained in this paper are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This paper may contain "forward-looking" information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this paper is at the sole discretion of the reader.

In Latin America, for Institutional and Professional Investors Only (not for public distribution). This material is solely for educational purposes only and does not constitute an offer or a solicitation to sell or a solicitation of an offer to buy any shares of any fund (nor shall any such shares be offered or sold to any person) in any jurisdiction within Latin America in which an offer, solicitation, purchase or sale would be unlawful under the securities law of that jurisdiction. If any funds are mentioned or inferred to in this material, it is possible that some or all of the funds have not been registered with the securities regulator of Brazil, Chile, Colombia, Mexico, Peru, Uruguay or any other securities regulator in any Latin American country, and thus, might not be publicly offered within any such country. The securities regulators of such countries have not confirmed the accuracy of any information contained herein. No information discussed herein can be provided to the general public in Latin America.

Issued in Australia by BlackRock Investment Management (Australia) Limited ABN 13 006 165 975 AFSL 230 523 (BIMAL). Any general information contained in this document is provided in Australia by BIMAL. Any distribution, by whatever means, of this document to persons other than the intended recipient is unauthorised. This document is intended only for wholesale clients and this document must not be relied or acted upon by retail clients (as those terms are defined in the Australian Corporations Act). This document is not intended for distribution to, or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation. This document contains general information only and is not personal advice. BIMAL is the issuer of financial products and acts as an investment manager in Australia. BIMAL is a part of the global BlackRock Group which comprises financial product issuers and investment managers around the world. This document has not been prepared specifically for Australian investors. It may contain references to dollar amounts which are not Australian dollars. It may contain financial information which is not prepared in accordance with Australian law or practices.

In the EU issued by BlackRock Investment Management (UK) Limited (authorized and regulated by the Financial Conduct Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited.

In Singapore, this is issued by BlackRock (Singapore) Limited (Co. registration no. 200010143N). In Hong Kong, this document is issued by BlackRock Asset Management North Asia Limited 貝萊德資產管理北亞有限公司 and has not been reviewed by the Securities and Futures Commission of Hong Kong. Not approved for distribution in Taiwan or Japan. In Canada, this material is intended for permitted clients only. In Latin America this piece is intended for use with Institutional and Professional Investors only. This material is solely for educational purposes and does not constitute investment advice, or an offer or a solicitation to sell or a solicitation of an offer to buy any shares of any funds (nor shall any such shares be offered or sold to any person) in any jurisdiction within Latin America in which such an offer, solicitation, purchase or sale would be unlawful under the securities laws of that jurisdiction. If any funds are mentioned or inferred to in this material, it is possible that some or all of the funds have not been registered with the securities regulator of Brazil, Chile, Colombia, Mexico, Peru or any other securities regulator in any Latin American country, and thus, might not be publicly offered within any such country. The securities regulators of such countries have not confirmed the accuracy of any information contained herein.

The information provided is not intended to be tax advice.  Investors should be urged to consult their tax professionals or financial advisors for more information regarding their specific tax situations.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets.

©2015 BlackRock, Inc. All rights reserved. BLACKROCK, BLACKROCK SOLUTIONS, BUILD ON BLACKROCK, ALADDIN, iSHARES, iBONDS, FACTORSELECT, iTHINKING, iSHARES CONNECT, FUND FRENZY, LIFEPATH, SO WHAT DO I DO WITH MY MONEY, INVESTING FOR A NEW WORLD, BUILT FOR THESE TIMES, the iShares Core Graphic, CoRI and the CoRI logo are registered and unregistered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

iS-15242-0515