This week the US Federal Reserve looks like it might finally do what is has not done for nine years — raise interest rates. The last time the Fed ticked its benchmark rate higher was in late 2006. In mid-2007, however, America’s central bank did an about face and starting lowering, all the way down to essentially zero at the end of 2008. Those last moves were part of a grand plan to help stoke the troubled US economy in response to the 2008 credit crisis and ensuing Great Recession.

For seven years now, short-term interest rates as set by the Fed have hovered near zero, but that may start to change. Recent comments from Fed chairwoman Janet Yellen suggest that a December interest rate “lift-off” is very much in play when the Federal Open Market Committee (FOMC) meets tomorrow. That leaves investors wondering what impact such a move might have on the markets.

Policy changes made after long periods of stability can be disruptive. A few months ago, China allowed its yuan currency to decline modestly after years of maintaining a tight peg to the greenback. Although the yuan declined just 3 per cent over the course of a week, the announcement sent the Chinese stock market tumbling and ultimately contributed to a major stock market correction around the globe in the third quarter. Being concerned about the collateral damage of even a subtle shift in monetary policy by the world’s largest economy is therefore quite reasonable, but individual asset classes should be reviewed separately.

To begin with, if we do see a bump in rates this month, money market funds and other short term deposit accounts should immediately benefit. The Fed controls short-term interest rates by setting the Federal Funds target rate which effectively determines the yields offered on Treasury Bills, commercial paper and other similar instruments. Money markets are mandated to buy these short duration securities and therefore should see marginally better returns almost immediately.

However, that does not mean it’s time to pop the bubbly. Most economists estimate that the Fed will start off very slowly, with an initial move towards 0.25 per cent. And even if the American economy continues to recover, the pace of future rate increases is likely to be very slow and gradual due to various geopolitical, demographic and structural headwinds still occurring.

Typically, when interest rates rise, bond prices fall. So time to dump those bond funds, right? Not so fast. While there is some truth to this argument, it is not really the whole story. First of all, the Fed is mainly controlling shorter-term rates while longer-term interest rates continue to be set by the market.

Factors influencing the direction and magnitude of changes in longer-term interest rates include investors’ expectation of inflation, perceptions of credit risk in various sectors of the market and prevailing interest rates in other countries. A large portion of the global bond market is more sensitive to longer-term rates than the shorter-term Federal funds rate and therefore could be more influenced by other salient factors.

The bottom line is that while a rising interest rate environment is never as good as falling rates for fixed-income as an asset class, it may not quite be the time to head for the hills. If the Fed raises rates very gradually, as most expect, longer-term interest rates might very well be contained within a reasonable range and some bond funds could come out okay.

Importantly, credit spreads, or the additional yield fixed-income investors receive above that for comparable Treasury notes have meaningfully expanded over the course of the past year. This enhanced credit spread may ultimately provide an important cushion against higher rates. At our firm, for example, we are overweight corporate bonds versus Treasuries.

Evaluating the impact of rising rates on the stock market is trickier. While “easy money” has historically been almost always good for equities, history has also shown that not all periods of “tighter money”, or rising interest rates, are bad years for stocks as a whole. A recent study by Wellington Management analysed 11 separate periods of rising interest rates starting in 1963. The study looked at returns on equities before, during and after Fed tightening cycles. The conclusion was that returns are lower than average when rates are rising but not catastrophic. In fact the average return during the first year of rate rising cycle was a positive 3 per cent. Notably, those who hung on after the last rate hike was implemented were rewarded with a median total return of 11 per cent.

Importantly, most studies including the above consider just the broad market indices and do not break down individual regions and sectors which may behave better or worse in a rising rate scenario. Intuitively, some interest-sensitive sectors such as real estate investment trusts (REIT’s) might be expected to underperform in a rising rate environment, at least initially.

On the other hand, sectors such as commercial banking could get a boost. Bank net interest margin, or the gap between what banks pay for funding and what they charge to lend, peaked at more than 3.8 per cent in 2010 and is now less than 3 per cent. Higher interest rates could help reverse the trend. JP Morgan, for example, recently stated that a 100-basis-point rise in interest rates would add $2.8 billion to its bottom line interest income.

While history can be a useful guide, such analysis should be used just as a starting point — each cycle is always a bit different. Trends to watch going forward include the stock and bond markets’ initial reaction to a change in policy, Fed indications of the trajectory of future hikes and the anticipated ending interest rate level. The key is not when the Fed raises but how far they go afterwards. In the meantime, sticking with a diversified portfolio of higher quality assets including some cash looks like a good bet.

Bryan Dooley, CFA is a senior portfolio manager at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information.

This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.