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Why A 1% Rise In Interest Rates Could Produce 'One Of The Worst Drawdowns In The Past 50 Years'

Why A 1% Rise In Interest Rates Could Produce 'One Of The Worst Drawdowns In The Past 50 Years'
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According to a new poll by the Wall Street Journal, more than 80 percent of economists believe the Federal Reserve will opt to raise interest rates again in December.

The Federal Reserve will likely want to get back on a consistent, predictable rate-hike schedule as soon as possible to continue the process of normalizing rates closer to their historical levels.

Bridgewater analyst Bob Prince recently took a look back at the last nine major Fed tightening cycles of the past 50 years to get some historical perspective on the long-term impact that rising interest rates could have on the stock market. According to Prince, the average tightening period lasted 21 months and raised interest rates by an average of 3.0 percent.

Stocks performed surprisingly well during those stretches, averaging a 6.5 percent gain. Prince noted that most of the stock market returns during these tightening periods came from EPS gains.

“The rise in earnings came from a continuation of sales and, to a lesser extent, margin growth during the final stages of a cyclical expansion, as it takes about a year for a tightening to slow the economy,” Prince explained.

Related Link: Argus Research Makes A Bullish Call On Financials

Usually, the productivity/wage ratio continues to climb throughout a tightening cycle, which supports company margins.

“In this cycle, the productivity/wage ratio was starting from extremely high levels (as the extreme weakness of the labor market following the crisis was very advantageous for companies) and has already begun to normalize, eating into profit margins,” Prince noted.

Unfortunately, Prince believes this tightening cycle could be extremely dangerous for the stock market.

“Even a 1 percent rise [in interest rates] would be one of the worst drawdowns in the past 50 years, overshadowed only by a few extreme events, like the tech bubble and the financial crisis,” he concluded.

Traders looking to protect themselves from a major Fed-driven sell-off in stocks should consider selling the SPDR S&P 500 ETF Trust (NYSE: SPY).

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