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Over the past two years, the Federal Reserve has delivered its most aggressive rate hiking cycle 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 activity. While we remain sceptical about whether such an outcome will be achieved, we are increasingly confident that a pause in rate hikes is approaching.
In this piece, we will use lessons from previous hiking cycles to assess the implications for markets. The key conclusion is that a pause is more consistently positive for government bonds than for equities.
Learning from past market moves
The path of the US economy following the last hike 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 watching the impact of their tightening working its way only slowly into the system.
Over the past 40 years, the median length of time between the last rate hike and the first cut is eight months, although the gap varies from just a single month in 1984 to 15 months after the last hike in 2006 (see Chart 1).
For equity markets, the first six months following the conclusion of a hiking cycle have typically been positive. The full effect of rate hikes takes time to feed through to weaker earnings growth, while equity valuations are often boosted by the signs of a shift towards a less restrictive stance from policymakers. Thereafter, however, the picture becomes muddier (see Chart 2).
The strongest equity returns were witnessed at the end of the 1994-95 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 rates by 250 basis points (bps) in the first 12 months after the last rate hike, 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 valuations clearly also play a key role in subsequent returns. At the time of the Fed’s final hike of the cycle in February 1995, the S&P 500 was trading on only 12x forward earnings, with multiples having fallen from 15x just a year before. The bursting of the ‘dot-com bubble’ sits at the other end of the spectrum, with the S&P 500 trading well above long-term averages at 24x 12-month forward earnings on the day of the last hike.
The end of the 2004-06 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 roll over, 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 10-year US Treasuries (see Chart 3).
While the mid-1990s soft landing was the best scenario for equities, it was the least strong for US 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 US Treasury yields above 12% and more than 300bps of rate cuts in the first four months after the last hike.
In conclusion, our analysis shows that in the period following the end of a Fed tightening 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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This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full magazine, click here.
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