Indexology^® Blog

It has been over nine years since the Fed raised interest rates, but today, the Fed raised rates just as expected. While the Fed actions have been well telegraphed, and interest rates are probably the least of worries for commodities, there is one measure that might be worrisome.

Although since 1991, rising rates seem not to have been a decisive factor in equity performance, and have clearly not been a negative force (as shown in the chart below from this paper,) there is more uncertainty about the stock market today than tomorrow. 

One indicator of extreme market stress can be seen when the price of futures contract on the CBOE Volatility Index® (VIX) with a nearby expiration is more expensive than one later dated. This condition is called backwardation (it sounds like a bad diagnosis and usually is) but it is relatively rare, happening in only 17% of days since Mar. 29, 2004.

The futures contracts are now reflecting this condition for five days straight. This has happened a number of times before but one of the interesting things about today is that the market seems not only uncertain but downright jittery. It looks a bit like in 2007, soon after the Fed starting raising rates, when the market felt noticeable fear by the measured backwardation. It’s not the fear alone but the persistence. Just a few months ago, from Aug. 20 – Oct. 7, the Chinese stock market crash sent chills through the market. Backwardation appeared again from Nov. 13 – 16 with one of the biggest weekly stock market drops in months that crashed the S&P 500’s 200-day moving average, a bearish signal for many investors. Again, ahead of the Fed decision – which should not have been surprising – backwardation appeared and is present. The chart below shows the history of VIX backwardation with the S&P 500 index levels. The green triangles represent when the Fed raised rates in 2006 and when they started quantitative easing in 2008.

While the interest rates alone have not influenced stock prices, the unprecedented quantitative easing started a vicious cycle of risk-on/risk-off (RORO) that was the result of a binary outcome for risky assets – either the easing works OR it doesn’t. Since commodities are a risky asset, they are a class where the returns are noticeably impacted by fear before the financial crisis and after, when quantitative easing began. Pre-crisis, there was no relationship between a high VIX and commodities, but the relationship turned negative post-crisis.

The RORO environment meant investors either felt they were, or were not getting paid for taking the risk to invest in risky assets. This drove up the correlation of commodities with stocks to unprecedented levels, just over 0.7. By 2013, the Fed started to taper and the correlation fell back to zero, and stayed below its average of 0.26 until Aug., 2015, precisely when VIX backwardation appeared. In just slightly more than one month, the correlation doubled from 0.22 (Aug. 20, 2015) to 0.44 (Sep. 28, 2015). Since then, it has increased slightly more to 0.46, its highest level in over two years, since Aug. 20, 2013.

The one thing to worry about is the combination of higher than average VIX backwardation with high risky-asset (stock/commodity) correlation. This only happened three times before now. Once in the financial crisis, once in 2011 just following the debt ceiling crisis and U.S. downgrade, and for a very short time in the 2010 flash crash. This is illustrated in the chart below where the S&P 500 represents stocks and the S&P GSCI represents commodities.

The S&P U.S. Issued High Yield Corporate Bond Index has just over USD1 trillion of par amount outstanding while its total return is down 3.11% for the month and down 4.51% YTD.  The energy and materials sectors have been the sore spot for the high yield market, given the anxiety over credit quality, as current low prices in oil and commodities, along with a Fed increase in rates, may be a cause for concern for future earnings and the cost of capital.  The return of the S&P U.S. Issued High Yield Corporate Bond Index ex energy and materials sectors would be less affected, returning -2.14% for the month and -0.05% YTD.

The growth of the high yield market since the 2008 financial crisis has been significant; the par amount outstanding of the S&P U.S. Issued High Yield Corporate Bond Index increased by 65% from Dec. 31, 2008, to Dec. 15,^, 2015.  As shown in Exhibit 1, the growth in issuance within the energy and materials sectors has been significant as well. At its highest in September 2014, the energy sector reached USD 207 billion and has since dropped to USD 122 billion.  Materials was as low as USD 33 billion in March 2009 before peaking at USD 102 billion in December 2014, and it was at USD 81 billion par outstanding as of Dec. 16, 2015.

Exhibit 1: Energy & Materials Sector Growth

Source: S&P Dow Jones Indices LLC., Data as of Dec. 15, 2015. Past performance is no guarantee of future results.  Chart is provided for illustrative purposes and contains hypothetical historical performance.

As the liquidity of recent markets have been tested by the impact of low energy prices a look at index design and results may be valuable.  Focusing on investment grade corporate  bonds we can see dramatic differences in depth of liquidity as a result of index design.

For investment grade corporate bonds two indices tracking these markets have very different liquidity profiles. Let’s compare the liquidity data of the bonds in the S&P 500 Investment Grade Corporate Bond Index to the broader S&P U.S. Issued Investment Grade Bond Index.  The S&P 500 Investment Grade Corporate Bond Index  provides a view of the performance of corporate bonds issued by the blue chip companies in the iconic S&P 500 Index,  other index inclusion criteria including par amount minimums are the same as the broader corporate bond index.

Results:

• More of the bonds in the index are trading each month: During the six month period of June through November 2015 bonds in the S&P 500 Investment Grade Corporate Bond Index had a higher percentage of trading each month: approximately 95% of the bonds in this index traded each month vs. 89% of the bonds in the S&P U.S. Issued Investment Grade Bond Index. Please refer to Table 1 below for the data.
• Fewer bonds but significant representation of the bonds trading: The S&P 500 Investment Grade Corporate Bond Index has fewer bonds than the broader index but the average trade volume of bonds in the index as measured by the number of trades, market value of trades and total market value of trades represent a high percentage of the trading volume of the broader index. Please refer to Table 2 below for the data.

Table 1: Trade Volume: Average Par Value Traded, % of Constituents Traded

Table 2: Trade Volume:  Market & Par Value Traded

The data illustrates that tracking the larger entities such as the blue chip companies in the S&P 500 Index results in significantly better liquidity characteristics for the underlying bonds than broader benchmarks.

As the Fed prepares to raise interest rates on Wednesday – or surprise virtually everyone – it is worth looking at the debt in the economy.  Interest expenses for most of it won’t move very much or very soon, but some believe the Fed is embarking on a two to three year process of pushing interest rates every upward.

The chart tells the story.  The pale green line with the peak at about 2008 is the domestic financial sector – banks, brokerages, insurance companies and so forth. Like most sectors, this one peaked as the financial crisis hit; unlike some sectors it has paid down a lot of debt and then resumed its climb. Since the mid 1990s the growth of financial sector debt outpaced everything else, it may be poised to outpace most other sectors going forward.  The red line – home mortgages — has the second largest dip after financials and it too is recovering.  Neither of these suggests a major change or retrenchment following the financial crisis.  Another sector that gets a lot of attention is the pink line trying to flatten out in the latest couple of quarters – federal government borrowings.  Corporate business, the gold colored line, staged a sharp rise in the last few years.

The bottom four sectors are a bit more stable and represent foreign borrowing in the U.S., state and local government debts, consumer credit and non-corporate borrowing.

The message here is two parts: one reason the last recession was called the Great Recession is the large and rapidly growing debt throughout the economy in 2007-2008; second is the hope that a small rise in interest rates and borrowing costs will moderate the current growth rates well before the next recession.

Tomorrow the Federal Reserve is expected to raise its benchmark Federal Funds rate by 25 basis points  — the first increase in seven years.   This increase, assuming that it comes, must surely rank among the Fed’s most advertised and anticipated moves ever, and Wall Street trading desks are ramping up in expectation of heightened trading volumes.   We have no special insight into the immediate or longer-term aftermath of the Fed’s decision — but we would caution that, for equity investors, there are at least three things that rising interest rates will not do.

First, they won’t tell us whether the stock market is going up or down.  There are good theoretical arguments to support the view that rising rates are bad for stocks.  If dividends are discounted at a higher rate, stock prices should come down, other things equal.  The problem is that other things may not be equal.  If rate increases come in response to a strengthening economy, they may be associated with rising stock prices.   In recent years, in fact, the U.S. equity market has been stronger when interest rates rose than when they fell.

Second, rising rates won’t cause stock market dispersion to increase.  Dispersion indicates by how much the best performing stocks in the market are beating the underperformers.  In a high-dispersion environment, a manager’s stock selection skill is worth more; if dispersion is low, his skill is less valuable.  Dispersion has been well below average for the past several years, which has contributed to the performance difficulties of most active managers.  But there’s no reliable evidence to suggest that an increase in interest rates will drive dispersion upward.  Whatever difficulties stock selection strategies faced with the Fed Funds rate at zero are likely to persist at 25 basis points.

Finally, rising rates won’t help us identify outperforming equity factors.  Rising rates don’t give us a reliable guide to the relative performance of growth vs. value, say, or of low volatility vs. high beta.  Through the first 11 months of the year, growth is well ahead of value, and low volatility well ahead of high beta.  Whether those trends continue or reverse is unlikely to depend on what the Fed does tomorrow.