The current rate-hike cycle began last year, after record-breaking policy rate cuts among global central banks responding to the economic impact of the 2020 global pandemic lockdowns.
In early 2022, stocks around the world began to slide into a bear market as central banks hiked rates aggressively in response to much higher than anticipated inflation. But now, signs are beginning to emerge that the trend in rate hikes may be nearing a peak, which may be welcome news for investors. History shows markets have often performed well on the other side of a Fed peak. However, this time around, there are a few key considerations as a peak comes into view.
Last month, Fed policymakers raised the Fed funds rate by 25 basis points (bps) to 5% in what was widely interpreted as a “dovish hike.” Fed Chair Jerome Powell paired the rate increase with a new emphasis on the risks to the US economy as the banking turmoil looked poised to curb credit availability to an unpredictable extent. With that, Powell and the committee introduced the possibility that the end of rate increases may be near. Investors expect the Federal Reserve to hike interest rates for the last time at the upcoming meeting in early May, as the economy shows early signs of slowing and inflation continues to ease.
Supercharged Cycle
Several aspects of this cycle seem to be unfolding ahead of schedule. This makes sense, given the fast-paced nature of the policy rate hikes and the way financial markets operate today.
For historical reference, since 1988, there have been six distinct US interest rate hiking cycles, including the current one that commenced in March 2022. On average, the Fed funds rate has been hiked by 275 bps in each tightening period over an average of approximately 16 months. The current tightening cycle has been historically swift with the Fed funds rate moving 475 bps in just over a year.
With the early signs of slowing in economic growth now visible, cooling inflationary forces and a fallout from financial market tensions lingering, any pause by the Federal Reserve after at least one more increase in May could cement a turn in what has been the most aggressive hiking cycle the world has seen in decades.
The European Central Bank (ECB) and regional counterparts might keep going longer and even aspire to keep restrictive settings in place, but a shift in gear for US monetary policy will be an important signal to global peers and financial markets.
Rallying after a Peak
In terms of risk assets, the Fed’s willingness to stop tightening is, all things equal, a tailwind. History shows markets have often performed well on the other side of the peak of a Fed hiking cycle, and so it may be no wonder that investors are fixated with changing expectations for how long the Fed will raise rates for, and for how long they hold at the eventual terminal rate.
The end of the interest rate hiking cycles highlighted above generated distinctly positive US equity returns over the ensuing 6-, 12- and 24-month periods, as shown in Figure 2. The time period that witnessed the clearest pattern of negative returns on the heels of a rate peak was the 1999-2000 hiking cycle. This was driven largely by the immense deflating of the tech valuation bubble of the early 2000s. From this perspective, we believe the valuation unwind has been front loaded in the current cycle, with the S&P 500 price-to-earnings (PE) ratio falling from 23x to 16x between early 2021 and October 2022.
It is worth noting that although equity returns following the 2006 tightening cycle were initially strong, the bear market and recession that followed the GFC were some of the longest and most severe in history, lasting from 2007 to 2009 and sending the S&P 500 down by 57%. The delay of the eventual downturn was due to a combination of factors, mainly the easy credit conditions that prevailed in the years leading up to the crisis, which fueled a housing bubble and excessive risk-taking by financial institutions.
The last time the Fed paused amid high inflation numbers was 1989. Then, as now, the index (S&P 500) was up over 8% year-to-date. There is only one other example of a pause with the policy rate being so low on a real basis (2018). In this instance, the S&P 500 surged 28% in the year after the Fed’s last hike in December 2018.
While investors are currently worried about the potential for the Fed’s rate hikes to induce a recession, on the positive side, inflation is likely to be significantly lower through the course of the year, and in 2024, than it is at present, which should allow the Fed to cut rates. Unlike in 2001, when the economy was suffering a hangover from the dotcom capex boom, and in 2007, when the economy was suffering a hangover from the housing bubble, the interest-rate sensitive sectors seem to be in fairly good shape today (commercial property being the possible exception). This means they could react quite promptly and positively to easier monetary policy.
The prospect of lower risk-free rates seems to be the most obvious driver of strong returns at the end of a significant hiking cycle. The prospect of just one more Fed hike should support equities, as should further easing in inflationary pressures over the next 6-12 months. Potential headwinds may come from growing evidence of a significant growth slowdown, stoking recession fears and the associated risk of significant downgrades to elevated 2024 earnings estimates. From this perspective, an emphasis on high quality defensive growth continues to be warranted.
This year has seen a strong rotation back to long duration growth sectors, most notably, tech. This appears to be driven by the rally in long bonds and the perception that quality tech companies will prove relatively defensive. Our style preference for the next 6-12 months favours quality (defensive earnings and high return on equity), followed by growth (bond yield sensitive), and then value (relatively more cyclical), though we see a degree of merit in all 3 styles on a medium-term view.
Gold has also been a strong performer this year, but may be due for a pause, but the prospect of the Fed pausing and then cutting may ultimately drive some further upside in the gold price over the next 6-12 months, as it has done in previous episodes.
Peak Rates, Peak Yields?
Historically, US Treasury yields have peaked a month or two before the last rate hike, as shown in Figure 4. This time around, fixed income markets pivoted in October 2022, instead of waiting for the Fed to pause. From the peak in the US 10-year Treasury bond in late October, at 4.33%, yields have fallen by about 75 bps to-date, suggesting the market may have reduced the profile for Fed policy rates, settling on a lower peak and speedier cuts. As discussed previously, this may prove too dovish, though the slowdown in US and global growth will likely keep the long end of the curve well bid over the coming year.
This sharp turnaround in Treasuries, which was exacerbated by the banking sector jitters in March, is another aspect of this cycle which has unfolded at an accelerated pace. It also suggests the expected decline in yields which typically follows a Fed peak and, by extension, the tailwind it provides equities, might have already played out to some extent.
While average returns during previous Fed hiking cycles have been subdued to outright negative, the average returns for bonds after the final rate hike have been distinctly positive for the subsequent 6-month, 1-year and 2-year periods, as shown on Figure 5.
Can the Fed Nail the Landing?
Not all of the Fed’s efforts to tighten monetary policy have been a success. Indeed, a number have led to recessions that lowered inflation but also killed jobs and economic growth, a ‘hard landing’. Others, like the 1994-1995 and 2018 tightening cycles, are considered classic ‘soft landing’ scenarios, with the Fed successfully cooling inflation but stopping before it broke the economy.
Policymakers have the challenging task of threading the needle between keeping rates just high enough to deal with sticky, albeit declining inflation, but not so high as to send the economy into recession. In our view, there is now enough evidence of a downtrend in inflation that the Fed will likely pause after the May meeting. How quickly they are prepared to ease will likely continue to be a function of the path of inflation over the coming year. The Fed does have a significant factor in its favour, namely, that the US labour market remains fundamentally strong. The absence of widespread layoffs should minimize the impact to employment, thereby limiting the damage to consumer demand and the broader economy. History reminds us that markets have often performed well on the other side of a Fed rate peak, particularly if the economy can avoid a genuine hard landing.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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