History shows that the investors invariably under-estimate the magnitude of interest rate increases during a US Federal Reserve (Fed) hiking cycle.
But despite ‘hawkish’ surprises in Fed policy rates that in the short term can be a ‘speed bump’ for risk assets, over the interest rate cycle as a whole they still typically post positive returns. Economic growth rather than Fed policy rates is the key medium-term performance driver for risk assets.
History shows that at the start of a Fed rate hiking cycle, investors underestimate how high the Fed policy rate will reach. The gold bar in Fig. 1 is the difference in basis points (bps) between the Fed funds target rate at the end of the hiking cycle (the ‘terminal rate’) and the rate implied by interest rate futures at the start of the hiking cycle. The blue bar shows the change in the (spot) US Treasury 10-year bond yield between the start and end of the Fed hiking cycle. The increase in the 10-year Treasury yield is invariably less than the cumulative increase over the cycle in Fed policy rates (shown in brackets on the horizontal axis) – a ‘bear flattening’ of the yield curve.
Fig.1: Markets typically underestimate magnitude of Fed rate hiking cycles
Note: the total increase in Fed funds target rate over each rate hiking cycle is in brackets. *150bps increase in Fed funds rate between Dec-17 and Dec-2020 implied by 20 September 2017 FOMC ‘dots’ is 150bps; December 2020 Eurodollar futures contract implies around 65bps increase in Fed policy rates over the 2-years to December 2020. The gold bar is the gap between the actual magnitude of Fed funds rate hikes and the increase implied by Eurodollar interest rate futures contracts at the start of the hiking cycle. The blue bar is the change in the US Treasury (spot) yield between the start and end of each Fed rate hiking cycle.
Source: Macrobond; Bloomberg; BlueBay calculations; latest data at 2 November 2017
The current Fed rate hiking cycle began with a well-flagged 25bps increase in Fed funds target range to ¼% - ½% on 16 December 2015. Thus far, the actual path of Fed rate hikes is close to market initial expectations as expressed in futures markets, hence the ‘rates gap’ to December 2017 is small (assuming that Fed policy rates are raised to 1¼% - 1½% at its next meeting). However, the final gold bar shows the difference between FOMC (the Fed’s interest rate setting committee) and market-implied forecasts for Fed policy rate by the end of 2020 is around 85bps, equivalent to more than three 25bps interest rate hikes. And if tax cuts are passed that meaningfully boost growth and inflation expectations, the FOMC is likely to raise rates by more than they currently forecast.
Growth-sensitive risk assets – equity, higher yielding credit and emerging market debt as well as convertible bonds – posted positive performance over the last three Fed rate hiking cycles despite the market failing to correctly discount the full magnitude of Fed increases in interest rates. Contrary to popular wisdom, Fed monetary tightening, even though rarely fully anticipated by markets, does not result in losses for growth-sensitive risk assets. Perceived shifts in Fed policy reaction function can destabilise, but risk assets typically shrug off more than expected Fed rate hikes if validated by strong economic growth.
Fig.2: Returns on selected risk assets during Fed rate hiking cycles
Note: the total increase in Fed funds target rate over each rate hiking cycle is in brackets. *125bps increase in Fed funds rate between Dec-15 and Dec-17 assuming Fed rates are increased by 25bps at its 13 December 2017 meeting. Bars show the change in the US dollar (DXY); BoAML US High Yield Index (USHY); JP Morgan EMBIG Global Index (EMD); S&P500 price index; and the Thomson Global Focus Convertible bonds (Converts)
Source: Macrobond; Bloomberg; BlueBay calculations; latest data at 2 November 2017
The notable exception is the 1994 when the timing and subsequent magnitude of the monetary tightening cycle came as a major surprise to investors. In the 1994-95 rate hiking cycle, most asset classes experienced losses – at one point the S&P500 was down 9% but subsequently recovered to finish 2% down over the cycle. Emerging market debt (EMD) performed especially poorly during this period, though in large part reflecting the Mexican ‘tequila’ crisis that intensified in December 1994 with a forced devaluation of the peso (Fed rate hikes added pressure on the peso but the main catalyst for the crisis was domestic political instability and an unsustainable policy mix).
The lessons from past and (so far) the current Fed rate hiking cycle are that investors invariably underestimate the magnitude of interest rate increases but that risk assets still post positive returns despite higher than expected rates. The notable exception is the 1994-5 episode when the scale of the shock was such that it led to dislocation in bond markets that spilled over into risk assets. History also confirms that Fed hiking cycles typically result in ‘bear flattening’ of the Treasury yield curve but not necessarily a stronger US dollar.
Download article: Higher than expected Fed policy rates do not roil risk assets
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Published November 2017