A look at the impact of federal funds rate increases over the last 30 years

Investors shouldn’t make any sudden moves when it comes to increases in the federal funds rate.
Investors shouldn’t make any sudden moves when it comes to increases in the federal funds rate.
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In December 2015, the Federal Reserve increased its target for the federal funds rate and hinted at plans to continue gradually increasing the rate over the coming years. As these changes in monetary policy begin, investors may be wondering if it is time to adjust their portfolios.

To determine whether a portfolio shift would be beneficial, analysts in Vanguard Investment Strategy Group looked at the performance of various sub-asset classes relative to the broad equity and fixed income markets during periods of federal funds rate increases over the last 30 years. They compared U.S. value, growth, small-cap, and large-cap stocks, U.S. REITs, and international stocks with the broad U.S. equity market, and U.S. corporate investment-grade, high-yield, and Treasury bonds with the U.S. aggregate bond market. The analysis showed that there is no predictable pattern of specific sub-asset classes performing better than the broad markets and concluded that sticking to current portfolio allocations, minimizing costs, and maintaining discipline make sense in this environment.

Historical uncertainty repeats itself

Successfully implementing a tactical strategy is challenging and risky. When considering a change to their portfolio allocation, investors must understand the risks and question whether they are able to take them on. The analysis below examines two sub-asset classes to show how seemingly logical tactical investment opportunities can lead to unexpected results.

Investors may view the Federal Reserve’s increase in the target rate as an indication of a strengthening domestic economy and high expectations for growth. A portfolio tilt toward small-cap stocks, which tend to be more domestically oriented (issued by companies that earn most of their revenues in the domestic economy), may thus seem like a suitable option. However, as we see in the chart below, small-caps behaved erratically throughout all five tightening cycles studied, sometimes making huge jumps within a short time. At the end of each tightening cycle, the return of small-caps relative to the broad equity market was inconsistent.

For their fixed income portfolios, investors who regard the increasing target rate as a signal that the economy is heating up may turn to U.S. investment-grade corporate bonds. They may be willing to take on the additional credit risk inherent in these bonds in their search for higher returns. Based on the research shown in the chart below, the behavior of investment-grade corporate bonds is anything but predictable. Even more interesting, over the five tightening cycles, they seemed to closely track the aggregate bond market, displaying a lack of outperformance contrary to what investors might expect. This could mean that the markets had already anticipated the cycles’ yield and spread changes.

Stay the course

Tactical shifts such as those described here don’t work because asset class performance does not depend solely on the direction of the federal funds rate. The rate alone does not cause any consistent behavior. Asset class returns are unpredictable, and other factors, such as the larger macroeconomic environment, should be considered when analyzing them. Therefore, a portfolio change based only on the expected path of the federal funds rate is not likely to lead to better long-term results. Assuming there is no change in circumstances and long-term goals, it would be prudent for investors to maintain a well-diversified portfolio.

Read the full analysis.


  • All investments are subject to risk, including possible loss of principal.
  • Diversification does not ensure a profit or protect against a loss.

This article was produced by Vanguard and not by the Quartz editorial staff.