1941 is best known as the year that Japan bombed Pearl Harbor and the U.S. entered into WWII. However, it is also the last time that interest rates were as low as they were at the end of 2012. Interestingly, just a few short years later in 1945, due to the cost of the war, the US Debt to GDP ratio was 120% which was considerably higher than current levels.  This time period also included the Federal Reserve’s (Fed) expansion of its balance sheet to levels comparable, on a relative basis, with today. For the next forty years, interest rates increased dramatically.

In 1981, Ronald Reagan entered the White House and then acting Fed Chief Paul Volcker increased the federal funds rate to 20% to combat the high levels of inflation in the 70s. The policy steps worked almost immediately, and caused interest rates to peak after their multi-decade upward march. For the next thirty-one years, through December 31, 2012, interest rates have generally decreased. The question on everybody’s mind is “what’s next?”

Influencing interest rates is the Fed’s monetary tool to either stimulate a contracting economy or restrain an over-heating economy. These policies have been used in every previous economic cycle.  Normally the Federal Reserve influences only short-term interest rates through establishing its fed funds target rates, and allows market participants to control longer-term rates as they factor in expected economic growth and inflationary concerns. Our current situation is different. Using standard Fed policies, Chairman Ben Bernanke has influenced short-term rates by lowering its fed funds target from 5.25% in late 2007 to 0% today. The Fed has also influenced longer-term rates through its quantitative easing (QE) bond buying programs, as the artificial demand for bonds has lowered yields. Lower interest rates across the entire yield curve have helped to provide the spark for our recent economic recovery.

Since November 2008 beginning with the QE1 initiative, the Fed has gone on to introduce QE2, QE3, & QE4. Operation Twist was also launched and designed to drive down long-term yields by selling the Fed’s short-term bonds and buying long-term bonds (however this measure was designed to be cash neutral and did not expand the Fed’s balance sheet). The combination of these stimulative programs has expanded the Fed’s balance sheet from $869 billion in late 2007 to $3.6 trillion as of July 31, 2013, plus an additional $85 billion per month from now until the bond buying is tapered and eliminated. Assuming that the Fed returns to 2007 balance sheet levels, it will eventually have to sell $2.7 trillion of bonds in the private marketplace in order to remove the additional monetary reserves that it has created over the last several years. These sales will dramatically increase the supply of bonds and theoretically increase interest rates as demand is outstripped by supply.

The good news is that the Fed does not have to set a date to completely unwind its massive bond position; 2018 to 2020 is the current projected time frame when the sales may ultimately be completed.  There is also a possibility that the Fed will alleviate some of the supply problem, by simply letting the bonds mature rather than sell them, although this option would extend its exit strategy by a couple of years. As a result of this eventual imbalance between supply and demand, there are many who think that we may revisit a longer-term trend of increasing interest rates. So it may be prudent to examine the previous increasing rate environment’s effect on both stocks and bonds, and its effect on the general economy.

From 1941 through 1981 the yield on the One-Month Treasury Bill rose from 0.04% to 14.72%, and the yield on the Ten-Year Treasury Note increased from 1.95% to 12.57% (peaking in 1982 at 14.59%). How much damage did this interest rate environment do? As it turns out, not much. During this extended period of generally rising interest rates, the Standard & Poor’s 500 generated an annualized return of 11.1%, slightly above its historical average. Short-term, high-quality bonds* didn’t fare as well, posting modest returns of 3.6% annually over the forty-one year period. A balanced portfolio of 60% stocks and 40% bonds returned 8.25% annually. As far as the economy, (and let’s face it folks, interest rates don’t generally rise dramatically unless there is sustained economic strength), GDP rose on average 4.1% over the period, well above the 3.2% long-term average historical rate.

Surprisingly, during the thirty-one year period of declining interest rates through December 31, 2012, the S&P 500 generated the same return of 11.1% per annum as it achieved during the sustained increasing interest rate environment. So much for historical evidence supporting that increasing interest rates adversely affect equity prices. Bonds however, performed materially better as rates declined, generating an average return of 8.22% per year, a return level that will likely not be repeated any time soon. The economy grew at a pace of 2.7% annually.

As we saw in late June, when Ben Bernanke hinted at tapering the bond buying program, there may be some short-term market volatility as the Fed eventually reduces its positions. It is anybody’s guess as rates begin to rise… how long they will rise… and how high they will rise. If history is any indication, rising interest rates should be no more than a speed bump, not a dead-end, as we travel down the road to prosperity and into another era of uncertainty.

* For the purposes of this analysis we have used the Five-Year US Treasury Note index as a proxy for a short-term, high-quality bond portfolio.This information is for educational purposes only and should not be considered investment advice or an offer of any security for sale.

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