When the Federal Reserve started raising rates in 1994, it drove interest rates up 2.5% in less than a year. The result was a bond market massacre that bled into stocks for a 3% loss on the year for the S&P 500. 
    
There’s no question that the Fed needs to normalize rates right now after an historic easy money policy but the question is, how quickly will rates increase and should investors be worried about a repeat of 1994?

#-ad_banner-#It’s a question that forced the market to a loss of 0.7% last year — and analysts are predicting still higher rates through 2016.

Against this fear in the market, there’s good reason to believe that rates aren’t going anywhere. If long-term rates stay low, it could be one of the biggest head-fakes of the year and lead to a huge rebound in rate-sensitive investments.

Rates Go Up, Treasuries Fall?
The Federal Reserve began its historic path to normalize rates after six years of easy money on December 16. Since that time, the rate on the 10-year Treasury has actually decreased by 0.15% rather than increased. Pundits will attribute the drop in rates to market volatility and global economic fears — but there is good reason to believe other factors will continue to keep interest rates at historic lows.

In its September update to economic projections, the FOMC consensus on economic growth came down considerably. The mid-point for 2016 GDP growth came down to 2.4% from consensus of 2.55% in June. Expectations for inflation also came down by 0.1% since the June statement. The members saw a range for the federal funds rate between 1.1% and 2.1% through 2016, well below the previous range of 1.4% to 2.4% for the year. Just four members see the rate over 2% at the end of the year compared to six members in June and three Fed members expect the rate to be under 1% for all of 2016.

The biggest weight on rates — which has been overlooked by the market so far — is the fact that the Fed is maintaining its policy of reinvesting principal payments from holdings of agency debt, agency mortgage-backed securities and rolling over maturing Treasury securities. The Fed has said that it will continue to reinvest these payments until, “normalization of the federal funds rate is well under way.” While rates on short-term notes may increase slightly, the Fed isn’t about to let long-term rates go much higher. 

While short-term rates in the United States may increase slowly, huge monetary programs in Europe and Japan will also act to keep global long-term rates low. The ECB has increased and extended its own bond-buying program through September 2017. Japan is still bent on increasing inflation by pumping money into its economy and China will need to cut rates to support its own growth. The ten-year German bund yields just 0.52% compared to 2.15% for the U.S. Treasury. This means there will be no lack for buyers of Treasuries as foreign investors search for yield.

The median projection of 51 economists in a Financial Times poll was for the fed funds rate to end 2016 at 1% and close 2017 just a percent higher. That would still put it well below the weighted average of 4.95% in 2006. 

I Foresee A Recovery Year For Rate-Sensitive Stocks
Rate sensitive investments had a tough time last year but could rebound in 2016 as investors realize rates are going nowhere fast. Many of these investments are also exactly the kind of safety-plays to which investors will be running if stock market volatility continues to climb.

Shares of the Vanguard REIT ETF (NYSE: VNQ) dropped 8% in 2015, though investors only lost 4.1% when accounting for dividends. The fund holds share in 154 REITs, diversified across all property types and across the United States. Rates hit real estate investments in multiple ways. Higher rates mean higher financing costs, especially in heavily-leveraged investments like real estate. 

Since REITs pay out more than 90% of income to avoid corporate taxes, they have to finance operations and growth with debt or by issuing equity. If rates go too high, the company may decide to issue more shares which would dilute current owners. Commercial real estate in the United States should benefit this year on a forecast by the World Bank of 2.8% growth as well as on still historically-low financing rates.  

Volatility on the iShares Core US Aggregate Bond Fund (NYSE: AGG) shot up to 3.85% in 2015, nearly a half percent higher than its historic average. Shares dropped 3.9% over the year though investors lost just 1.5% after dividends. The fund offers broad exposure to the U.S. investment grade bond market with holdings in Treasuries (38%), mortgage-backed securities (28%) as well as corporate and agency debt. Amidst the market selloff, the bond fund has gained 0.5% as investors scramble back to safety.

Dividend stocks, especially those in rate sensitive sectors like utilities could do well as investor sentiment returns. Bond holdings bought before 2006 will continue to mature and investors will be looking to reinvest money for yield, yield that’s no longer available in fixed income investments. The Utilities Select Sector SPDR (NYSE: XLU) was the third-worst performing sector ETF last year, falling 8.3% and only underperforming Energy and Materials. The sector pays a 3.7% yield and is one of the only to post a gain so far in 2016. 

Risks to Consider: Some rate-sensitive investments like real estate and dividend stocks are also sensitive to economic growth and may underperform if the economy fails to meet expectations.

Action to Take: Position in rate-sensitive investments as the market realizes interest rate increases will come much more slowly than expected.

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