It seems clear that the next move in US interest rates will be down rather than up. However, when that cut will come is a source of fevered debate. The markets are anticipating a cut as soon as this month, while the Federal Reserve (Fed) is trying to push expectations further out. Is the Fed behind the curve? If it is forced into ‘panicked’ interest rate cuts, as implied by the Fed futures market, it could have real implications for asset prices.
Using data going back to the mid-1980s, we found that there were six distinctive Fed loosening cycles that could be classified as either a “pause” or a “panic”. The four Fed pauses, where the central bank cut interest rates modestly (October 1987, July 1995 and September 1998) or guided on being patient in raising rates (February 2016) were in response to a slight softening in the macro data.
The two Fed panics, which led to the Federal Open Market Committee (FOMC) cutting interest rates aggressively, occurred from January 2001 (following the dotcom overvaluation stock market bubble) and from September 2007 (during the global financial crisis, when the global financial system was leveraged to the US housing market). Crucially, when the Fed began to loosen during a panic, the central bank was viewed by the market to be reactive to unfolding events, rather than proactive, and this led to a loss of investor confidence, which in turn led to a recession.
Today, it is important we define whether the Fed is panicking or whether this is a reasonable and timely response to changing economic risks because it can have a fundamental impact on financial market returns. Our analysis shows that US equities rallied on average 23% over the twelve months from the start of a Fed pause. In contrast, when there is a panic, our calculations show US equities fell on average by 16% over the next twelve months.
There is a similarly divergent impact on other asset classes: US treasury prices have risen significantly after a panic rate cut, but stayed stable after a pause. It is a similar picture for US investment grade corporate bonds. High yield credit, in contrast, saw a slump after a panic rate rise, but stronger performance after a pause.
So where are we today? There are undoubtedly risks. Trade sentiment is poor. Even though Donald Trump and Chinese President Xi Jinping have agreed a temporary truce on tariffs, there are longer-term issues to address and US/China tensions are likely to remain. This suggests that conditions could merit a fall in rates, but we view such a Fed move as a pause, rather than a panic. That’s because when we look back over history at metrics such as the yield curve, private sector employment growth, manufacturing production and real consumer purchasing power, there is little to suggest that the Fed is behind the curve.
The last set of GDP growth figures showed the economy growing at 3.1%. Unemployment remains near record lows. While there is some disruption to the manufacturing sector as a result of the trade war, the consumer is well-supported and retail sales continue to climb.
As a result, we are still in the growth camp for the time being and thus back equities over bonds. We see a recovery in earnings per share underpinned by a productivity recovery, share buybacks and high profit margins. The consumer is still supported by lower interest rates and these are likely to remain in place. At the same time, corporate debt risk – a key concern for markets – appears to be contained. There may even be favourable news from the Eurozone as Chinese stimulus supports Eurozone trade. To our mind, this does not suggest a panic by the Fed.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
Investment does involve risk. The value of investments and the income from them can go down as well as up. The investor may not receive back, in total, the original amount invested. Past performance is not a guide to future performance. Rates of tax are those prevailing at the time and are subject to change without notice. Clients should always seek appropriate advice from their financial adviser before committing funds for investment. When investments are made in overseas securities, movements in exchange rates may have an effect on the value of that investment. The effect may be favourable or unfavourable.
This article was previously published on www.smithandwilliamson.com prior to the launch of Evelyn Partners.