Lessons Learned from Past Federal Reserve Tightening Cycles Tracey M. Manzi, CFA Vice President, Investment Services, Cammack Retirement Group
For nearly six years, the Federal Reserve has held short-term interest rates at essentially zero to support the economy after the 2008 financial crisis. The severity of the Great Recession, and the Fed’s inability to lower interest rates below zero, led policy makers to use unconventional tools to stimulate the economy, such as quantitative easing (i.e., large scale asset purchases) and forward guidance. With strong employment gains and an improving economy, the Fed is now preparing the market for an eventual rate increase, perhaps as early as June 2015. Considering the timing and potential magnitude of the Fed’s next tightening cycle, we thought it instructive to look at how financial markets have behaved in past cycles for clues as to what might happen when the rate cycle does eventually turn.
HOW RISK ASSETS BENEFITED FROM QUANTITATIVE EASING A short review is warranted as to how risk assets, such as domestic equities, high-yield bonds and real estate securities, have performed since the Fed resorted to extraordinary measures to kick-start the economy. As the chart below demonstrates, the Fed’s aggressive policy response to the Great Recession has rewarded investors for taking on risk. This reaction has led to a strong and sustained rise in asset prices since 2009, albeit with some interim volatility.
PAST FED RATE HIKE CYCLES An exploration of past Fed tightening cycles starts with a review of how monetary policy adjustments work. One of the main tools Fed officials use to adjust policy is the federal funds rate. Whenever policy makers want to slow the growth rate of the economy and restrain inflation, they may raise interest rates, which is known as “tight”, “restrictive” or “contractionary” monetary policy. Conversely, whenever policy makers desire to spur the growth rate of the economy and increase the supply of money and credit, they lower interest rates, known as “easy”, “expansionary” or “accommodative” monetary policy. Over the last 30 years, five different tightening cycles have taken place. As seen in the following chart, interest rates have steadily declined during this period, where the interest rate in the current tightening cycle has peaked at a rate lower than in the prior tightening cycle. This is largely attributable to the Fed’s success in maintaining a low inflationary environment since the late 1980’s.
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Designates Starting Date of Tightening Cycle
March 30, 1988 Dec 18, 1986 June 30, 1999
Feb 4, 1994
June 30, 2004
Data: Federal Reserve Bank of St. Louis The chart below lists the Fed’s five most recent tightening cycles, detailing the timing and magnitude of rate increases once policy turned more restrictive. A quick calculation shows the federal funds rate rose by an average of 2.7% in the past tightening cycles and lasted for approximately one year. The only exception was the 2004 tightening cycle.
While each tightening cycle has been driven by different factors, past history may provide guidance on what to expect when rates eventually do head higher. As the old adage goes, history doesn’t repeat itself, but it often rhymes.
LEADING INTO THE FIRST RATE HIKE One common factor in the months leading up to each of the Fed’s initial rate hikes was an improving macroeconomic environment. This was most clearly evidenced by the labor market data. In each cycle, the unemployment rate had steadily declined and non-farm payroll growth was very strong. Other leading indicators, such as the Purchasing Managers Index (PMI) and hourly earnings, were also increasing. Inflation data, however, suggested no predictable trends. In most tightening cycles, inflation had either held steady, or only started to gradually rise after the Federal Reserve began to hike interest rates. It appears that the Fed’s decision to raise rates in each of the tightening cycles was driven by trends in the labor market and the central bank’s desire to be preemptive on the inflation front, rather than reacting to rapidly rising inflationary pressures.
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MARKET REACTIONS IN PAST TIGHTENING CYCLES To understand how rate hikes impact the financial markets, we examined the performance of both stocks and bonds in each of the last five tightening cycles. While most investors think rate hikes negatively impact the financial markets, our analysis shows the opposite is true. Rate increases have historically led to greater equity market volatility, but they have rarely signaled the end of a bull market. As the chart below reveals, the stock market continued to rise in the last five tightening cycles. While market corrections are always possible, they typically do not happen until the Fed has completed or nearly finished its tightening cycle. Both the 1999 and 2004 tightening cycles did end with major stock market crashes; however, this had more to do with exogenous factors, such as the dotcom crash of 2000 or the financial crisis of 2008, than it did with overly restrictive monetary policy.
Designates Starting Date of Tightening Cycle March 30, 1988 Dec 18, 1986 June 30, 1999
Feb 4, 1994
June 30, 2004
Data: Federal Reserve Bank of St. Louis Drilling down a little further leads to a review of the total return of the S&P 500 in the months preceding the Fed’s initial rate hikes and the months thereafter. Our analysis shows that in four of the last five cycles, stocks generated positive returns six to twelve months after the Fed first increased the federal funds rate. As the chart below indicates, the market declined in three of the last five tightening cycles in the months immediately following the Fed’s first rate increase. But after the initial shock of the policy shift wore off, the market regained its losses and resumed an upward trend despite further rate increases. The only exception to this pattern occurred in the 1994 tightening cycle. A review of the 1994 cycle suggests the market behaved differently then, as participants were surprised by the timing and aggressiveness of the Fed’s tightening campaign.
Data: Morningstar and BlackRock
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It is now time for a closer look at the bond market. The chart below compares the 10-year U.S. Treasury rate to the federal funds rate. While the market has been in a secular bull market in bonds for the last 30 years, some countertrend selloffs have occurred during this time. As per the chart below, most bear markets in bonds have occurred during Fed rate hike cycles. The 2004 tightening cycle was a rare exception.
Designates Starting Date of Tightening Cycle
March 30, 1988 Dec 18, 1986 June 30, 1999
Feb 4, 1994
June 30, 2004
Data: Federal Reserve Bank of St. Louis In 2004, long-term interest rates remained remarkably stable, trading in a very narrow range, despite the Federal Reserve’s interest rate hikes from a low of 1.0% to 4.25%. In most instances, long-term interest rates should rise when policy makers increase short-term interest rates. The bond market’s unusual reaction in 2004 has prompted a great deal of discussion regarding the factors behind it. While no consensus has yet emerged as to why the market behaved so differently in 2004, many believe that the driving factors were global foreign purchases of U.S. Treasuries, increased demand from pension funds for longer-dated maturities and decreased macroeconomic uncertainty.
Basis Points
We also reviewed the average change in U.S. Treasury yields three months before the Fed’s first rate hike until the end of the tightening cycle. As the chart below demonstrates, interest rates rose across the yield curve during past Fed rate hike cycles. As expected, shorter-term maturities, such as 2-year Treasuries, absorbed the majority of the rate increases, while longer dated maturities, which are influenced by factors other than just monetary policy changes, increased by significantly less.
Data: Federal Reserve Bank of St. Louis
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Since bond prices move inversely with yields, it may seem counterintuitive that the bond market, as measured by the Barclays Aggregate Bond index, averaged modestly positive returns during past rate hike cycles. As the chart below shows, bonds have not experienced the apocalyptic losses investors feared in past bear markets. We attribute this to the fact that in previous tightening cycles, a bond investor was able to earn a coupon with a high enough interest rate to offset the price decline that comes from rising interest rates.
Data: Morningstar and BlackRock While the bond market’s average returns have been mostly positive in past tightening cycles, bonds can nevertheless generate negative total returns. This outcome is evidenced by bond returns in the 1994 tightening cycle, when investments across the maturity (i.e., 2-year Treasuries to 30-year Treasuries) and the credit spectrum produced negative total returns in absolute terms. As discussed, this was primarily due to the surprise timing and pace of the Fed’s rate actions during the 1994 tightening cycle. We also reviewed of the broader asset classes during the last five tightening cycles to see how returns were impacted by the Fed’s rate actions. As the chart below depicts, the broader asset classes produced positive total returns during the time periods examined. While the returns provided below represent the average return over past tightening cycles, the individual cycles may have varied. For example, commodities generated positive returns in four of the five periods; the only exception occurring in the 1994 cycle. REITs generated positive returns in three of the five periods, producing an average return of 7.1% one year after the Fed’s initial rate hike. The high yield bond sector largely shrugged off the negative impact of higher interest rates, producing positive total returns in three of the five cycles. Finally, international developed markets gained in four of the five periods, generating double-digit returns in most periods one year later.
Average Total Returns for the Broader Asset Classes During Past Tightening Cycles
Commodities REITs High Yield MSCI EAFE
3 Months Before 3.4% 2.2% 2.1% 5.7%
3 Months After 8.7% 2.9% 1.6% 4.6%
6 Months After 10.4% 6.4% 3.1% 13.5%
9 Months After 21.1% 3.2% 2.5% 18.5%
12 Months After 26.7% 7.1% 4.2% 12.8%
Data: Morningstar, DataStream, BlackRock
PUTTING IT ALL TOGETHER: INVESTMENT IMPLICATIONS Now that we have reviewed how the markets behaved in past tightening cycles, what impact will the upcoming rate cycle have on today’s markets? If history were to repeat itself, most major asset classes should produce positive total returns during the next tightening cycle. However, we say this with some trepidation as there are numerous reasons why the next rate hike cycle may impact the financial markets differently. Most significantly, the Fed’s unprecedented policy response to the Great Recession may have created special challenges that markets have not had to deal with before.
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As discussed, Central Bank action has been the primary driver of stock and bond returns following the 2008 financial crisis, with the S&P 500 increasing more than 200% from the lows reached in 2009, and 10-year U.S. Treasury yields declining from 5.0% to an all-time low of roughly 1.5%. These major market moves have undoubtedly contributed to more stretched valuations than those leading into prior tightening cycles. Factoring in the impaired market liquidity, which has been a consequence of the structural and regulatory changes that occurred in the aftermath of the financial crisis, suggests that the upcoming rate hike cycle could increase volatility and alter how financial markets may perform in the upcoming tightening cycle. If past is prologue, stock investors should not fear the Fed in a rising rate environment. However, with the stock market hovering near its all-time price peak and earnings multiples at historically high levels, caution is warranted. This means investors should temper their expectations for a continuation of double-digit gains once the Fed begins to move away from its zero-interest rate policy stance. The outlook for the bond market appears less sanguine. Given the low level of interest rates, high-quality bonds, such as U.S. Treasuries, may not be able to generate positive total returns once the Fed’s tightening cycle begins. With interest rates hovering near their all-time historic lows, the income earned may not be sufficient to offset the negative price impact from rising rates, particularly if the upcoming tightening cycle produces rate increases similar to what we have seen in the past. However, global factors, such as increased demand from overseas investors and quantitative easing by foreign central banks, may keep interest rates from rising as much as might otherwise be expected during the average tightening cycle. Despite commonalities experienced during past tightening periods, it is important to remember that every rate hike cycle is different than the last. As we approach a new period of rising interest rates, investors should take a fresh look at their asset allocations and use this as an opportunity to rebalance if necessary. A well-diversified portfolio should help investors fare well regardless of the direction of the interest rates or the economy.
KEY TAKEAWAYS • No two Fed rate hike cycles or set of economic conditions are identical. Each cycle must be judged on its own merits. • The Fed’s decision to raise rates in the past has been driven by trends in the labor market and the central bank’s desire to be preemptive on the inflation front. • If history were to repeat itself, most major asset classes should be able to produce positive total returns during the next tightening cycle. • High-quality bonds, such as U.S. Treasuries, may produce negative total returns if rate increases are similar to what we have seen in the past.
ABOUT CAMMACK RETIREMENT GROUP Cammack Retirement Group is a leading provider of investment advisory, consulting and actuarial services. We work with the nation’s leading academic and research institutions, healthcare providers, corporations, non-profit organizations and public sector employers to help them manage fiduciary risk. For more information on our services, please contact Mike Volo, Senior Partner, at 781.997.1426 or
[email protected]. Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Past returns are not indicative of future performance. Investment products available through Cammack LaRhette Brokerage, Inc. Investment advisory services available through Cammack LaRhette Advisors, LLC. 65 William Street, Suite 100, Wellesley, MA 02481 | p 781-237-2291
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