Beyond the pause: What happens after peak rates?
Over the past two years, the Federal Reserve (Fed) has delivered its most aggressive interest rate increases in over 40 years. Yet despite these efforts to slow down the US economy, growth has so far proven remarkably resilient. This resilience has led to increased optimism around the prospects for a “perfect landing” – whereby inflation moves back to target without a significant hit to the economy. While we remain sceptical about whether such an outcome will be achieved, we are increasingly confident that a pause in rate increases around the globe is approaching.
In this piece, we will use lessons from previous rising rate cycles to assess the implications for markets. The key conclusion is that a pause in rate increases is more consistently positive for government bonds than for equities.
Learning from past market moves
The path of the US economy following the last interest rate increase in the cycle can vary widely. There are times where the economy cracks quickly, leading to a swift about-turn from policymakers and rapid rate cuts. At other times, economic resilience can result in an extended period where rates are kept on hold, with policymakers waiting for the impact of their rate increases to work their way into the system.
Over the past 40 years, the median length of time between the last rate increase and the first cut is eight months, although the gap varies from just a single month in 1984, to 15 months after the last increase in 2006 (Exhibit 1).
Exhibit 1: Interest rate changes following the Fed's last rate increase in the cycle
For equity markets, the first six months following the peak in interest rates have typically been positive. The full effect of rate increases takes time to feed through to weaker corporate profits, while equity market valuations are often boosted by the signs of a shift towards a less restrictive monetary policy stance from policymakers. Thereafter, however, the picture becomes muddier (Exhibit 2).
Exhibit 2: S&P 500 returns around the Fed’s last rate hike in the cycle
%, price return indexed to zero at the last hike
The strongest equity returns were witnessed at the end of the 1994-95 interest rate rising cycle, one of the few examples in recent history of a “soft landing” where a Fed pause did not lead to rising unemployment. With the economy holding up well, the Fed held rates close to their peak and the equity market made new all-time highs.
The experience of the early 2000s was evidently very different. A rapidly deflating technology bubble forced the Fed to cut interest rates by 250 basis points (bps) in the first 12 months after the last rate increase, and by a further 225bps in the following year. This easing was not enough to support the equity market, with the S&P 500 falling nearly 25% over the two-year period.
In addition to the resilience of the economy, equity market valuations clearly also play a key role in subsequent returns. At the time of the Fed’s final increase of the cycle in February 1995, the S&P 500 was trading on a relatively low valuation (based on the forward price-to-earnings ratio), and was also more attractively valued than just a year before. The bursting of the dot com bubble, on the other hand, sits at the other end of the spectrum, with the S&P 500 trading well above long-term valuation averages on the day of the last rate rise.
The end of the 2004-2006 cycle is another noteworthy example, whereby an initial period of economic resilience (accompanied by an extended pause in interest rates) supported stocks for over a year. Yet once the economy began to slowdown, rate cuts were not enough to relieve the pressure on equity markets, with investors ultimately giving up all of the initial gains they had made following the Fed pause, and more.
Bond returns show greater consistency
The historical pattern is more conclusive in the bond market, with the end of each tightening cycle over the last 40 years leading to positive returns for US 10-year Treasuries (Exhibit 3).
Exhibit 3: US 10-year Treasury returns around the Fed’s last rate hike in the cycle
%, total return indexed to zero at the last hike
While the mid-90s soft landing was the best scenario for equities, it was the least strong for Treasuries, even though the asset class delivered two-year total returns of 17% despite only minor interest rate cuts. At the other end of the spectrum, the 1984 pause led to the strongest returns, helped by a starting point for 10-year Treasury yields above 12% and more than 300bps of rate cuts in the first four months after the last increase.
While past performance should not be relied upon as a guide to the future, our analysis does show that in the period following the end of a US interest rate rising cycle, US Treasuries have delivered more consistently positive performance relative to their equity counterparts. Against a backdrop of elevated valuations for US equity benchmarks today, and with still much uncertainty about how far the US economy will slow, history suggests that a moderate tilt towards fixed income over equities may be a prudent approach until the extent of any slowdown ahead becomes clearer.
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