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Rate hikes coming, but then what?

The next meeting of the Federal Reserve’s Open Market Committee is about a month away, but the betting money still seems to lean toward the first hike in short-term rates in nearly a decade.

Evidently, the people looking for a rate hike didn’t read the minutes from the July meeting that were released Wednesday.

“Most judged that the conditions for policy firming had not yet been achieved, but they noted that conditions were approaching that point,” the minutes said, summarizing the opinion of the committee members.

“Participants observed that the labor market had improved notably since early this year, but many saw hope for some further improvement. Many participants indicated that their outlook for sustained economic growth and further improvement in labor markets was key.”

The staff report on inflation and the economy went even further: “Although energy prices and non-oil import prices were expected to begin rising steadily next year, the staff continued to project that inflation would be below the committee’s longer-run objective of 2 percent over 2016 and 2017.”

To be sure, whether it is in September or December or 2016, the Fed will eventually raise short-term rates. The question on the minds of most investors is what effect the move will have on the financial markets.

“Conventional wisdom is that rising interest rates are bad for equities,” said Craig Lazzara, head of index investing strategy at S&P Dow Jones Indices. “But in the last 25 years, the presumed relationship between equity performance and interest rates has been severely challenged.”

In the past 35 years, research finds that over the three, six and 12 months after a rate hike, the S&P 500 gained 1.5 percent, 6.1 percent and 5.3 percent, respectively, said Ehiwario Efeyini, senior research analyst at Bank of America Merrill Lynch.

In other words, despite the sharp sell-off in stocks last week, Efeyini says, “Equity valuations still look attractive relative to bonds.”

More than stocks, there is a link step relationship between rising interest rates and bond prices, often challenging the belief that bonds are safer than stocks.

“Duration is everything in a rising rate environment and bonds with long durations are prone to bigger price swings as yields change,” said Roger Rieger of S&P.

“What we may see is floating rate bonds and debt returning to favor as rates begin to move upward. The interest rates paid out to holders of floating-rate U.S. Treasury bonds should begin to rise along with the rising rate environment.”

Bottom line: The worst may be over for the financial markets, especially bonds, when it comes to the threat of a slow but steady increase in interest rates by the Fed.

“Investors who have been waiting on the sidelines for interest rates to rise may want to consider the possibility that yields may not rise as much as they anticipate,” said Kathy Jones of the Charles Schwab Center for Investment Research.

“Markets often discount future events and the signals from the bond market suggest that tighter Fed policy is helping hold down bond yields, not increasing them.”

Chamberlin is executive editor of The Daily Transcript.

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