Stress Testing for a Fed Rate Hike with Three Scenarios

In a November poll of academic and business economists surveyed by The Wall Street Journal, 92% said they expected the Federal Reserve to raise interest rates in December, the first such hike in more than nine years. Ahead of this month’s Fed meeting, we used the MSCI Macroeconomic Risk Model and RiskMetrics® RiskManager to stress test three interest-rate scenarios and quantify their potential effect on a diversified portfolio of global stocks and bonds.

The three scenarios we tested were (1) an early and aggressive series of rate increases, (2) a delayed and less aggressive series of hikes, and (3) a series that was ideally timed and modulated to address changing growth and inflation levels.

We found that these three scenarios produced very different results. Raising rates too much and too fast could stall the economy and lead to deflation. Raising them too little and too late could ignite inflation, also curbing growth. If the Fed gets things just right, we might see domestic growth trends return to pre-2008 levels, accompanied by slightly higher, but mostly benign, inflation.

For each scenario, we began by using our Macroeconomic Risk Model to forecast how the Fed’s actions might influence risk factors for selected equities, government bonds and currency markets. In a second step, we used RiskManager to apply each of these initial risk factors to a broader set of related factors. Finally, we assessed how the risk factor test results would affect two global, multi-asset class portfolios denominated in U.S. dollars—one unhedged, the other hedged.

As the exhibit below shows, our series of stress tests indicated that the unhedged portfolio would suffer most if rate hikes were delayed; returns for the first year would be -6.6%. Even if the timing of rate hikes were ideal, that test portfolio would gain just 1.1%. The hedged portfolio would hold up better with delayed rate increases, returning -1.9%, but it would return -3.2% if rate hikes were more aggressive. Our test showed the best outcome was produced by a hedged portfolio in an environment of ideally timed increases, gaining 2.4% for the year.

Fed rate hike stress test results

The results represent the market impact of the Fed rate hike stress test. While the macroeconomic indicators develop over a one-year horizon, markets reaction typically occurs much more quickly.

For further information

To learn more about this recent study, see our Research Insight, The Fed Rate Hike: Implications for U.S. and Global Multi-Asset Class Portfolios. Download the study