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Three charts to explain rate rises, asset prices and Yellen's dilemma

Equities and bonds suffer in a tightening rate cycle

Interest rate rises reduce consumer spending, which has the knock-on effect of reducing corporate revenues and ultimately profits. A higher interest rate also means the future cash flows of a company, from which its equity market value is derived, are more heavily discounted. As shown in the graph below, real equity returns - stripping out inflation - are strongest when interest rates are falling (the blue bar), and weakest when they are rising (the turquoise bar).


Some falls are bigger than others

The research also considered how each sector has historically responded to interest rate hiking or easing cycles, by looking at sector returns minus the overall market return.

Unsurprisingly, those sectors with greatest exposure to consumer spending are usually hardest hit by rate hiking cycles (the blue bar), such as consumer durables and retail, and improve with falling rates (the turquoise bar). The more defensive sectors move in the opposite direction.


Diversification works (except when you need it)

Private investors wanting to shelter from the pain of rising rates in real assets will be disappointed. The graph below show the difference in annualised return in the two years following rate falls, compared with the two years following rate rises.

In short, real assets also do better with falling rates, rather than rising rates.

It must be said that in a week when banking stocks are driving markets lower partially due to concerns at the impact of low (and even negative) rates for longer, the 'low rates is good news for markets' message is harder to hear.

But the markets have clearly struggled to digest December's US rate hike, leading the Bank of England and other central banks to soften their stances, and Ms Yellen has an incredibly tough decision to make on whether to proceed further.

Credit: The above graphs and taken from the Credit Suisse report's chapter 'Cycling for the good of your wealth', written by the London Business School's Elroy Dimson, Paul Marsh and Mike Staunton.