The Federal Reserve is likely to leave interest rates unchanged in April, raising the potential for more volatility in the stock market.
The central bank held rates steady when it met in March and also back in January amid the large swings in the market as oil prices plummeted to record lows and fears of a global slowdown rose. The pace of rate hikes is predicted to decline in 2016.
“The market’s assessment of a likely interest rate hike in April remains miniscule,” said Edison Byzyka chief investment officer of Hefty Wealth Partners in Auburn, Ind. “The probability currently stands at less than 10% and given the dovish dot plot in March, the probability is likely to drop closer to 5%.”
The probability of a rate hike in April remains very low although recent remarks by several regional Fed bank officials “indicated that there was a credible case to be made” for the Fed raising rates next month in April, said Robert Johnson, president of The American College of Financial Services in Bryn Mawr, Pa.
Effect on the Market
When interest rates start to rise, the returns of the stock market are “markedly lower than when rates are trending downward,” he said. The S&P 500 returned 15.2% annually when rates were falling from 1966 through 2013 and only 5.9% when rates were rising.
Stock market volatility also tends to decline when interest rates are in a rising rate environment compared to when there is a declining rate environment. During falling rate environments from 1966 through 2013, the standard deviation of annual returns was 16.3%, Johnson said. When interest rates were increasing, the standard deviation was only 14.4%.
“Investors should not assume that volatility will be higher as rates rise,” he said.
The glide path of interest rates will continue to impact the market’s returns, said Matthew Tuttle, the portfolio manager of Tuttle Tactical Management U.S. Core ETF (TUTT).
“Markets rallied on dovish comments from Yellen and then started to weaken when they saw dissension in the ranks,” he said. “The Fed remembers what happened in December when they raised rates and the market declined 10%.”
Increasing interest rates too soon could dampen returns, and now the Fed is “between a rock and a hard place,” Tuttle said. “They would like to normalize rates, but they don't want to be responsible for a massive market decline.”
The Fed is likely to hold off on raising rates for awhile unless “we get economic data that is too good to ignore,” he said.
In the near term, investors must cope with continued volatility until the Fed increase rates from 0.25%.
“This means that the choppy markets that we saw last year and so far this year are here to stay,” Tuttle said. “We will see tons of volatility, but it is unlikely the market will break out either way until Fed policy becomes clearer.”
Investors are facing headwinds since activity in the market will continue to have “large up and down swings,” but is likely to still yield flat returns, he said.
“Once the Fed starts tightening, that will be the nail in the bull market coffin,” Tuttle said. “Investors need to take a tactical approach because buy and hold and asset allocation just won't work.”
The markets will not generate large returns this spring and investors should focus on maintaining a global diversified portfolio and take advantage of buying stocks while they are cheaper, said Jon Ulin, a managing principal of Ulin & Co. Wealth Management in Boca Raton, Fla.
“Just remember it’s all about your time in the markets and not timing the markets,” he said. “It is highly possible for the U.S. market bulls to run a few more points this spring and recapture their highs from last year. It may be difficult for the S&P 500 index to make a clean breakthrough before the end of this year of the high of 18,312 set last May.”