Wealth Insights | Asset Allocation | Investing101 | Equities | Fixed Income
Investing 101: What might happen after the end of a US interest rate hiking cycle
Posted on
Key Takeaways:An end to rate hikes impacts both fixed income and equities. Historically, following a peak in interest rates:
|
Interest Rates And The Fed
The Federal Reserve (‘Fed’) sets the central fed funds interest rate for the US economy with the aim of maximizing economic growth while adhering to a dual mandate of low and stable inflation and maximum employment. Decisions on rate adjustments are made with reference to a variety of key economic indicators.1
Changes in interest rates affect asset classes differently. We explore how the end of a hiking cycle might affect fixed income and equities. We explore how the end of a hiking cycle might affect fixed income and equities.
What Happens When Hikes End?
Over the last 50 years eight notable interest rate hiking cycles took place. In each of these periods, the fed funds rate hit a peak before hikes were paused and subsequently cuts began.
The time between the last hike in a series and the first cut, ranged from 15 months in 2006 to 1 month in 1984, with an average pause of 7 months between the last hike and the first cut.
Fixed Income After Rate Peaks
Fixed income has a direct relationship with interest rates. While yields move in tandem, prices have an inverse relationship – as interest rates are decreased, bond prices tend to rise, leading to greater total returns.
On the next page, we show the total returns for the Bloomberg US Treasury Index over the 24 months following the last interest rate hike of a series. In all instances, Treasuries showed positive total returns over the period.
Total returns for the index were greatest following the 1981 and 1984 interest rate peaks, where the starting yields were also high: 14% and 12.5%2 respectively.
Source: CPB Global Investment Lab, Bloomberg. Monthly data from 1 January 1973 to 31 January 2024.
In addition to changes in interest rates, the total returns of fixed income investments are impacted by the maturity and coupon sizes of bonds. Credit quality equal, bonds with longer maturities and lower coupons will have greater sensitivity to changes in interest rates. This is quantified by a measure called ‘duration’, with a longer duration signifying a greater price sensitivity to changes in interest rates.
We illustrate this below with indices of US Treasury bonds of various maturities. We see that the longer duration bonds showed overall greater price changes in the 2 years following Fed Fund rate peaks.
Source: CPB Global Investment Lab, Bloomberg. Monthly data from 1 January 1995 to 31 January 2024. Duration as of February 15th, 2024.
Equities Following Peak Rates
Equities, as measured by the S&P 500 index also generally performed well historically following a peak in interest rates, although with less uniformity than US Treasuries.
The periods that showed the strongest equity performances were those in which a US recession did not follow in the wake of the high-rate environment (1984, 1995, 2018).
The period following the 2000 interest rate peak ended in negative equity performance and coincided with the burst of the dotcom bubble that saw equity valuations come down from 27x in 2000 to 16x to 20223.
Source: CPB Global Investment Lab, Bloomberg. Monthly data from 1 January 1973 to 31 January 2024.
Looking within equity returns to sectors (see table on next page), there is no consistent historical beneficiary of interest rates peaking and beyond for the period for which we have data. Nor do we note a strong distinction between Cyclical and Defensive sectors. This is unsurprising given the unique issues present in every cycle.
We can note that with the exception of the 2000 rate peak, the information Technology sector outperformed the S&P 500 index in the other periods. Consumer Staples and Health Care also outperformed during 3 of the 4 periods.
Source: CPB Global Investment Lab, Bloomberg. Monthly data from 1 January 1995 to 31 January 2024.
1Board of Governors of the Federal Reserve System, “Monetary Policy Principles and Practice”, 2024
2Bloomberg US Treasury Yield to Worst as of May 29th, 1981 and August 31st, 1984. Yield curve was inverted in 1981.
3Source: Bloomberg S&P 500 Index Price/Earnings Ratio as of January 31st, 2000 and September 30th, 2022
*Source: CPB Global Investment Lab, Board of Governors of the Federal Reserve System, “Changes in the Intended Federal Funds Rate, 1971-1992” and “Policy Tools Open Market Operations”, 2024. Rate change is total change over 24 months following the start of period interest rate peak. Past performance or correlations are no guarantee of future results. Real results may vary.
