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  4. Here's why the economy has been so resilient in the face of rate hikes - and why stocks aren't at risk as the Fed keeps policy tight

Here's why the economy has been so resilient in the face of rate hikes - and why stocks aren't at risk as the Fed keeps policy tight

Aruni Soni   

Here's why the economy has been so resilient in the face of rate hikes - and why stocks aren't at risk as the Fed keeps policy tight
  • Many businesses and consumers are locked into low-cost debt, insulating the economy from rate hikes, BofA says.
  • The economy will slow "meaningfully" when rate hikes are ultimately felt, but it won't bring a recession.

The Federal Reserve has briskly raised interest rates to rein in red-hot inflation brought on during the pandemic, and investors have been on edge trying to assess the impact of the central bank's efforts.

But through it all, GDP numbers have come in hot, consumer spending has been strong, and the job market is showing few signs of weakening.

For those who are confused about why the economy has been able to weather the swiftest rate hikes in 40 years, Bank of America analysts say it's due to the long period of abnormally low-interest rates following the Great Recession that only ended in March 2022 when the Fed embarked on its inflation fight.

That's also why the outlook for equities isn't as ominous as many forecasters say — rates may feel high, but they're still pretty tame relative to history.

"A key reason for resilience is the relatively slow transmission of interest rate increases to the real economy, as a large share of households and businesses have locked in low borrowing costs and don't yet need to roll over their debt," analysts Aditya Bhave and Mark Cabana wrote in a note published Wednesday.

The Fed kept rates near zero following the 2008 crisis in order to stimulate economic activity. Both households and corporations got used to ultra-low-cost debt, making the current run-up in rates feel more painful.

But many borrowers are still locked into loans they signed when interest rates were low, so they haven't had to take on those higher costs yet.

While the impact of higher rates has yet to be felt fully, the BofA analysts say it won't spark a recession when it does hit.

"Looking ahead, we expect the economy to slow meaningfully in the coming quarters as higher front-end and long-end rates take their toll on credit conditions. However, we think there is enough momentum in the economy to avoid an outright recession." they said.

It's a similar story for the stock market, which has been pressured by rising interest rates since the Fed began hiking borrowing costs.

But again, the abnormally low-rate period prior to 2022 is a reason why the outlook for the stock market isn't all that bad. While the spike in rates is expected to ripple through the economy and weigh on corporate profitability, BofA analysts say there are important "nuances to consider."

"Rates are not excessively high, they just feel high relative to a decade of ZIRP (zero interest rate policy)," the analysts wrote. "Zero was too accommodative in 2021, and 5% is closer to average rather than ultra-high."

So while investors may be fretting over how and when rate hikes could impact the market, the period of rising interest rates since March 2022 is more of a return to normalcy.

The frenetic bond market has also been a concern for investors as Treasury yields have been rising on expectations of tight Fed policy. That's because when bond yields rise, they give investors an attractive way to get solid, nearly risk-free returns relative to equities.

But when accounting for inflation, real yields haven't risen enough to truly dent the stock market's competitive edge, the analysts argue.

"10yr [Treasury] real yields today of 2% to 3% based on break-evens are below average and not particularly competitive with equity returns," they said. "Our valuation framework suggests price returns of 6%, or ~8% total returns per annum over the next 10 years."


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