As if two stock market corrections in 2018 were not enough, another major sell-off just before Christmas, gave investors a “three-peat”, and left all major market indices squarely in the red at year’s end. For the US benchmark S&P 500, it was the first time in a decade that the index closed a year with a loss. Decidedly, stock market volatility is back, and with a vengeance!

Needless to say, a lot of uncertainty had been weighing on investors for a good while, everything from trade wars to various geo-political concerns. By December, those concerns began to multiply, amid new worries over slowing economic growth. Then the price of oil plummeted. But, the final straw for investors was the Federal Reserve decision to take interest rates up another notch, the 4th increase for the year.

Coming into 2019, stocks are back on the upswing, particularly after the Federal Reserve Chairman Jerome Powell re-iterated the central bank’s intention to remain flexible in the face of market turbulence and signs of slowing economic growth. It was exactly the re-assurance investors were looking for.

Without a doubt, interest rates matter to investors – a lot! Rising rates, and the overall trend to tighter monetary policy was a major theme in 2018, setting a new tone to the investment climate.

Generally speaking, when central banks choose to increase interest rates, the aim is to slow down borrowing and spending to keep the economy from getting over-heated, and maintain inflation at reasonable levels. But, in today’s context, inflation is less of a concern, at least for the present. At this point, central banks are also seeking to “normalize” monetary policy, in the wake of the 2008 financial crisis. With the economy on more stable footing, the time had come to bring rates back up to more neutral levels. Plus, as interest rates go up, the Federal Reserve continues to unwind its quantitative easing programs, which is also having an impact. So monetary policy is tightening in a couple of ways and financial markets are feeling the squeeze.

The table below shows how the lending rates of the Bank of Canada and the Federal Reserve have fluctuated over time. As you can see, the current rates of 1.75% in Canada and 2.25% in the US are still very low by any historical measure, yet these represent a sizable increase in the cost of borrowing, over a relatively short period of time.

The Bank of Canada Benchmark Rate dictates the interest rate at which banks borrow and lend money to each other overnight. It’s closely watched since it is a strong indicator as to where other interest rates are headed.

The Federal Reserve maintained near zero interest rate policies for several years, and the transition back to “normal” was always going to be a big adjustment. Both central banks, US and Canadian, have indicated that any further increases in rates will continue to be incremental, and will be very much contingent on the economy’s capacity to continue to absorb higher rates, without slowing the pace of growth.

But, the Federal Reserve has the greater challenge when it comes to getting the right balance with its monetary policy. Chairman Jerome Powell also has to take into account the impact of higher rates on global trade and economic expansion outside US borders. While the US continued to fair well economically in 2018, the rest of the globe did not fully participate in the upside. And with tighter monetary policy in the US, the value of the greenback has soared, along with the cost to borrow in US dollars. The result has been dislocations and stress throughout the global economy.

So what does this all mean for your investments? Most of you already understand the inverse relationship between bonds and interest rates. Fixed income assets have been under pressure for a few years now due to rising interest rates. But, we are also seeing the impact on stock values, as the recent stock market turbulence demonstrates. In 2018, higher interest rates have brought considerable volatility to both bond and stock prices, leaving investors with little place to hide! Let’s look at each of these asset classes separately, fixed income and equities, to better understand how that relationship works.