- Macro Strategist
Denmark, Institutional
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With the first Federal Reserve rate hike expected in March, I looked at US equity market performance in the wake of previous policy lows, as shown in Figure 1. In the three months following the first tightening, we’ve typically seen the broad market weaken and defensive names dominate. Looking further out toward the 12-month mark, total returns have tended to improve.
Observations on specific sector results
I think a few details in the table are notable:
- Within cyclical sectors, energy, financials, and materials held their own in the immediate aftermath of the first tightening.
- Real estate and utilities stood out for their extremely strong performance in the last two expansions, as both were characterized by falling rates.
- Health care did well in two of the three expansions following the first tightening (the sector also screens well for being low duration and low beta).
I’d also note that defensive sectors have tended to do better in the 12 months after a Fed move than in the 12 months leading up to the move.
With all that said, this expansion is different for a lot of reasons, including the Fed’s use of both balance sheet and interest rates as policy tools, which makes extrapolation challenging.
Figure 1
A few thoughts on bond yields
There has been a lot of interest in bond yield behavior as well, which is highlighted in Figure 2. Yields typically rise ahead of the first rate hike, but then they often move down after tightening begins. This is consistent with somewhat weaker equity returns in the three months after the first Fed move. The exception was 1994, when the rate cycle was continuously revised upwards for a time.
Figure 2
Looking at market pricing of Fed rate hikes and comparing it to prior rate tightening over an expansion, there is room for the terminal rate (how high rates can go over the course of an expansion, as opposed to how much they might rise in the near future) in the US to move higher in the right global environment. Recently, in fact, market pricing for the terminal rate, which had been in the 1.75% – 2.00% range, moved north of 2.00% for the first time, and it could go higher.
The one new variable is that with Fed balance sheet runoff as an additional tool, there could be more of a tradeoff between rate hikes and balance sheet, which deserves monitoring. I continue to watch the shadow rate as a way to put the two together.
In conclusion, the move in real and nominal yields thus far in 2022 is consistent with what we have seen in prior rate tightening cycles. Looking ahead, easing supply-chain pressures should give the Fed some room in the adjustment process. Over time, I would expect some firming in real rates, especially as the starting point is quite low.
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