Investment Forum Historical lessons from Federal Reserve rate-hike cycles Martin Hochstein, CFA Senior Strategist Macro / Fixed Income Allianz Global Investors Discussions about the timing and magnitude of the next US rate-hike cycle have heated up. Conventional wisdom seems to suggest that a tightening of monetary policy should weigh on financial markets in general and risky assets in particular. The good news is that this assumption is not corroborated by historical evidence. Looking ahead, however, the upcoming rate-hike cycle could be unique in its impact on financial markets. Understand As we head towards the end of large-scale asset purchases by the Federal Reserve (the Fed ), discussions about the timing and magnitude of the next US rate-hike cycle have heated up. While monetary policy is supposed to limit the amplitude of the business cycle, financial markets exhibit distinct return patterns during periods of rising and falling central-bank rates. To assess the impact of higher central-bank rates on a broad array of asset classes we have analysed historical episodes of monetary policy tightening in the United States. Fed rate-hike cycles duration and magnitude Our analysis is based on the Federal Reserve s six rate-hike cycles since 983. We restrict ourselves to this time period in order to ensure the comparability of the episodes with regard to the underlying monetary-policy regime. When looking at the duration of the six tightening cycles, we see that they lasted, on average, for 44 days, i. e. almost 4 months, and that the Fed increased interest rates by an average of 28 basis points during those periods. Clearly, as Chart shows, the length and extent of the episodes varied considerably. This is a strong reminder that every cycle has its own characteristics and needs to be assessed against the respective macroeconomic and financial-market backdrops. But nevertheless, almost all the episodes or at least most of them had something in common, and we may be able to draw some important conclusions for the upcoming cycle. Understand. Act.
Chart : Fed rate hike cycles since 983 Fed rate hike cycles since 983 Fed funds target rate (%) Average change of Fed funds target rate 2. Start End Days Start End Days / 2/983 8 / 2 / 984 477 8..7 +3.2 2 / 6 / 986 9 / 4/987 262.87 7.2 +.37 3 / 29 / 988 2 / 24 / 989 332 6. 9.7 +3.2... 2 / 4/994 2 / /99 362 3. 6. +3. 6 / 3 / 999 / 6 / 2 32 4.7 6. +.7 6 / 3 / 24 6 / 29 / 26 729..2 +4.2 44 +2.8. 8 9 9 8 27 days (t=: start of 6 Fed rate hike cycles since 983) Fed funds target rate In our analysis, we exclude the 2bp one-off rate hike by the Fed in March 997. Source: Allianz Global Investors, Bloomberg, as of 3.7.24 US economy around the first rate hike One factor common to all cycles was the improving macroeconomic environment in the run-up to the first rate hike. Typically, the labour market had been making constant progress for some time, reflected in a declining unemployment rate and a strong rise in non-farm payrolls. Growth in cyclical sectors had gained momentum and industrial production was rising at a faster rate. GDP had grown at a decent pace for several quarters prior to the first rate hike in most instances. It was an improving labour market rather than surging inflation that forced the central bank s hand over the past 3 years. The inflation trend, on the other hand, was not as clear-cut. Indeed, core inflation rates bottomed out in the quarter after the first rate hike, on average. Broad inflation rates, however, turned around or were already on the rise at the onset of most cycles. Judging the Fed in light of its dual mandate, historical evidence suggests that it was an improving labour market rather than surging inflation that forced the central bank s hand over the past 3 years. Did analysts anticipate rising central-bank rates? But how well prepared were analysts and financial markets for higher central-bank rates at the beginning of each cycle? Did the consensus correctly anticipate the magnitude of upcoming rate hikes? In our view the blunt answer is: no. When scrutini zing the last three cycles, we can see that analysts seemed to have regularly underestimated the rate hikes subsequently delivered by the Fed (see Chart 2). The consensus constantly had to revise its medium-term forecasts for short-term interest rates upwards during the early months of each episode. However, the degree of surprise varied significantly, with the cycle in 994 being the negative outlier. During that period analysts continued to be caught on the wrong foot, not only with regard to their Fed funds rate forecast but also with regard to their expectations on the long end of the US yield curve. Over the first nine months of that cycle, the consensus had to lift its mid-term forecast for the Fed funds target rate by 23 basis points and for -year Treasury yields by almost 2 basis points. Below, we will take a closer look at the corresponding impact of that surprise on the financial markets in this period. 2
Chart 2: Analysts underestimated the magnitude of the last three Fed rate hike cycles Consensus forecasts: US 3-month interest rate (in year) 2. 2.. Consensus forecasts: US -year interest rate (in year) 2. 2.. change (%).. change (%)........ 6 3 3 6 9 6 3 3 6 9 months (t=: start of Fed rate hike cycle) months (t=: start of Fed rate hike cycle) 994 999 24 994 999 24 Source: Allianz Global Investors, Consensus Economics, as of 3.7.24 Asset markets mostly undeterred by Fed action First let us examine the average performance of major asset classes during all six rate-hike cycles. Conventional wisdom seems to suggest that a tightening of monetary policy should weigh on financial markets in general and risky assets in particular. The good news is that this assumption is not corroborated by historical evidence. It might come as a surprise, but financial markets had been mostly undeterred by the Federal Reserve s rate hikes over the past 3 years (see Chart 3). On average, all major asset classes were able to post positive absolute returns during those episodes. Commodities and notably industrial metals and energy, which are the most growth-sensitive subsectors did particularly well, with an average gain of more than 2 %. But equities also shrugged off the potentially negative impact of higher rates. US equities recorded positive absolute returns in out of 6 rate-hike cycles, rising by an average of almost %, while global and Emerging Market equities achieved even higher gains. Furthermore, Chart 3: Asset markets mostly undeterred by Fed action Average return of asset classes during Fed rate hike cycles Commodities() 2.2 Average return of US equities EM equities (4) 8.9 Global equities (4) US equities (6) US money market (6) US TIPS (2) US high yield (6) 9.9 7. 6.6. 4.6 US Treasuries (6) 2. US corporate bonds (IG) (6).9 Global government bonds (6).9 2 3 average return during Fed rate hike cycles (%) 8 9 9 8 27 days (t=: start of 6 Fed rate hike cycles since 983) US equities (S&P ) Number of Fed rate hike cycles considered since 983 in brackets. Global equities, Emerging Market equities and global government bond returns in local currency. Number of episodes with positive absolute returns: commodities (4 out of ), EM equities (3 out of 4), global equities (3 out of 4), US equities ( out of 6), US money market (6 out of 6), US TIPS (2 out of 2), US high yield (4 out of 6), global government bonds (3 out of ), US Treasuries (4 out of 6), US investment grade corporate bonds (4 out of 6). Source: Allianz Global Investors, Bloomberg, Datastream, BofA Merrill Lynch Past performance is not a reliable indicator of future results, as of 3.7.24 3
US equities tended to perform well in advance of the first rate hike. In all episodes, they posted positive returns in the three months before the start of the cycle. Conventional wisdom seems to suggest that a tightening of monetary policy should weigh on financial markets in general and high-risk assets in particular. The good news is that this assumption is not corroborated by historical evidence. However, the biggest surprise is the positive performance of all major fixed-income segments, as they ought to be directly harmed by rising interest rates. Be it Treasuries, global government bonds or corporate bonds, all were at least slightly in the green, with inflation-linked bonds and US high-yield as the clear outperformers, posting average gains of more than %. Despite these apparently favourable results, it has to be pointed out that the absolute performance of all fixed-income segments lagged behind the returns achieved in the money market. The vicious rate-hike cycle of 994 Before we get too carried away by these favourable average results, we have to come back to the vicious rate-hike cycle of 994. This episode is a good example of what could go awry from a financialmarkets perspective when central banks start to tighten monetary policy. Though in early 994 Chairman Greenspan, in his usual Delphic style, had already been hinting at potential rate hikes for some time, the timing and magnitude of the subsequent monetary tightening came as a major surprise to analysts. Obviously this surprise spilled over into the financial markets (see Chart 4). Unexpected and poorly communicated hikes take their toll on financial markets. Over the course of the cycle almost all asset classes suffered losses, with global and Emerging Market equities hit the hardest. But US equities lost ground as well, temporarily losing almost % before finishing the cycle at minus 2 %. Chart 4: Financial markets caused by surprise the vicious cycle of 994 Return of asset classes during rate hike cycle in 994/9 US equities and Treasury yields US money market 4.6 2. US high yields Commodities.2.4.2 US equities Global government bonds 2. 2.4 change (%). US Treasuries US corporate bonds (IG) 2. 2.8.2 Global equities EM equities 2.6 6.6 2. 8 9 9 8 27 36 3 return during Fed rate hike cycle in 994/9 2 days (t=: start of Fed rate hike cycle in 994) US equities (S&P ) US Treasuries (yield > y, rs) Global equities, Emerging Market equities and global government bond returns in local currency Source: Allianz Global Investors, Bloomberg, Datastream, BofA Merrill Lynch Past performance is not a reliable indicator of future results, as of 3.7.24. 4
One of the most important lessons to be learned from historical rate-hike cycles is the relationship between financial-market returns and the degree of surprise caused by changes in monetary policy. Well flagged and anticipated rate hikes were digested rather well by most asset classes. Unexpected and poorly communicated hikes as in 994, however, took their toll on financial markets. The miracle of positive US Treasury returns Let s have a closer look at fixed-income markets now. As mentioned before, even US Treasuries were able to post positive average returns over the course of these episodes, despite a significant rise in interest rates. While yields rose on average between basis points for longer maturities and 23basis points at the short end, which confirms the strong flattening trend of the yield curve during most episodes, Treasuries counterintuitively returned between.4 and 4.4 %, depending on the maturity (see Chart ). Only in the cycles of 986 / 87 and 994 / 9 did US sovereigns suffer losses. But what is the reason behind this apparent return miracle? It s all about the current yield of the Treasury market. In a nutshell, losses caused by higher interest rates had been more than compensated for by the coupon that could be earned during most cycles. What impact would an average rate-hike cycle have on US Treasuries today? With the benefit of hindsight, it might be interesting to evaluate the impact of an ordinary rate-hike cycle on US Treasuries in today s environment. We therefore ran a simulation, calculating bond-market returns assuming a rise in interest rates in line with the average of the previous six episodes of monetary tightening by the Federal Reserve. Chart : US Treasuries were able to eke out positive returns during most Fed rate hike cycles US Treasury yields: Change during Fed rate hike cycles 2 Average return of US Treasuries 2 232 4 4.4 88 basis points 63 4 % 3 2 2. 2.3. 3 3 7 7 + Overall.6.4 3 3 7 7 + maturity (years) average rise of interest rates during 6 Fed hike cycles (since 983) maturity (years) average return of US Treasuries during 6 Fed hike cycles (since 983) Source: Allianz Global Investors, Bloomberg Past performance is not a reliable indicator of future results, as of 3.7.24
Chart 6: US Treasuries could potentially suffer losses due to the small current yield cushion. Assumed change of US yields based on past Fed cycles US Treasuries: return impact of an average rate hike cycle today 4 3.3 3 % 6 4.3 3.3 4.8 % 6. 2 9 2.4 3 3 7 7 + maturity (years) Yield to maturity (current) Yield to maturity (end of cycle) Overall 3 3 7 7 + maturity (years) Note: Calculations based on current US Treasury yields (as of 7/3/24) and on average historical duration and interest rate changes of Fed rate hike cycles since 983. Source: Allianz Global Investors, Bloomberg This hypothetical simulation is based on historical data and makes assumptions about future market conditions that may not occur. No representation is made that these results will occur under any market conditions, as of 3.7.24 In such a scenario, Treasuries could potentially suffer losses between.3 % at the short end and over % at the long end of the curve due to the negative price impact and the lack of a current yield cushion (see Chart 6). Investors might be surprised by the negative return effect of rising interest rates on bonds in today s low-yield environment. This is another important lesson to be learned: compared to history, investors might be surprised by the negative return effect of rising interest rates on bonds in today s low-yield environment. Bear flattening in periods of rising central-bank rates Historically, most of the damage to US Treasuries was usually done early in the rate-hike cycle. While Treasury yields rose by an average of around basis points over the course of all episodes, almost two thirds of this move (around basis points) occurred in the first five months of the cycle (see Chart 7). Moreover, interest rates already started to rise approximately days before the first Fed action. Overall, the yield curve had a strong tendency to flatten, turning round well in advance of the first hike (around 8 days). Clearly, bear flattening, which means a flatter curve at higher yield levels, was the prevailing regime during almost all rate-hike cycles. Fixed-income spread segments with a moderate tendency to tighten What happened to the spread segments of the US bond market? On average, as we have already seen, all segments were able to record positive absolute returns through the cycles. In general, investmentgrade corporate bonds and high-yield spreads had a slight tendency to tighten on an asset-swap basis during most episodes. To some extent, however, this was offset by a widening of Treasury swap spreads. With regard to US high-yield paper, strong absolute performance and outperformance relative to Treasuries has primarily been driven by the high current yield, not by tighter credit spreads. Unfortunately we have only limited historical data to evaluate the impact of rising Fed fund rates on Emerging Market bonds. But anecdotally, EM hard currency bonds had a strong tendency to tighten over the previous two rate-hike cycles. 6
Chart 7: US Treasury rates and the yield curve US Treasury yields around the start of Fed rate hike cycles. Flattening of the yield curve dominated.2.....2.4. 8 9 9 8 27 days (t=: start of 6 Fed rate hike cycles since 983) US Treasury yields (> year).6 8 9 9 8 27 days (t=: start of 6 Fed rate hike cycles since 983) US Treasury curve (7 vs. 3 y) US Treasury curve (+ vs. 7 y) Source: Allianz Global Investors, Bloomberg, as of 3.7.24 Chart 8: Relative performance of fixed income spread segments Spread change of fixed income segments US TIPS breakeven (2) US corporate bonds IG (6) US high yield (6) EM sovereign bonds USD (2) 2 88 24 3 average spread change (basis points) during Fed rate hike cycles 2 Corporate bond (IG) and high yield spreads tended to tighten average ASW spread change (basis points) 8 4 4 8 8 9 9 8 27 days (t=: start of 6 Fed rate hike cycles since 983) Number of Fed rate hike cycles considered since 983 in brackets. Source: Allianz Global Investors, Bloomberg, as of 3.7.24 US corporate bonds IG US high yield Act Despite what all or most episodes have in common, every rate-hike cycle has its own characteristics and needs to be evaluated within its individual context. On average, nevertheless, all major asset classes were able to post positive absolute returns at times of rising Fed fund rates, with commodities and equities performing particularly well. As demonstrated by the 994 cycle, however, financial markets responded negatively when they were caught by surprise, be it with regard to the timing or the magnitude of rate hikes. With respect to the current situation and the still observable mispricing at the short end of the US Treasury curve, it is therefore essential for the Federal Reserve to get its communication right in the coming months, and to align the financial markets excessively moderate rate-hike expectations with its own scenario. Looking forward, the upcoming rate-hike cycle could be unique in its impact on financial markets. 7
Looking forward, the upcoming rate-hike cycle could be unique in its impact on financial markets for several reasons:. With regard to monetary policy we are still living in extraordinary times. The Fed has to manage the unprecedented transition from non-traditional back to traditional monetary policy. Never before have rates been raised while running a historically large balance sheet with a huge amount of excess reserves. Correspondingly, there are significant risks that financial markets have become unduly addicted to the high degree of monetary stimulus. 2. At the same time the Federal Reserve, like the Bank of England, is using its forward guidance to assure markets that forthcoming rate hikes would be gradual and limited in scope, and that the terminal fund rate of the cycle is expected to be well below historical norms. We will see how this works out over time. 3. As for the markets, US Treasuries in particular but also other bond market segments have to deal with the small current yield cushion. Rising interest rates should therefore do more harm to fixed-income investors today in comparison with historical incidents. 4. And last but not least, we are approaching the next cycle in an environment of impaired market liquidity. For structural and regulatory reasons, banks and broker / dealers won t be able to fulfil their usual role as bond-market intermediaries, absorbing potential bonds sold by real-money and other investors. Not least for that reason, we may have to get used to higher volatility the closer we get to the first rate hike. Appendix Chart 9: US economy around the first rate hike US growth and inflation around the start of rate hike cycles. Economic pickup usually well entrenched. 4...... 2 2. 6 3 3 6 9 months (t=: start of 6 Fed rate hike cycles since 983). 4 6 3 3 6 9 months (t=: start of 6 Fed rate hike cycles since 983) US GDP (yoy) US core CPI (yoy) US unemployment rate US industrial production (yoy, rs) On average, US core inflation bottomed two months after the first Fed rate hike. Source: Allianz Global Investors, Bloomberg, as of 3.7.24 8
Chart : Global government bonds in lockstep with Treasuries Global government bond yields rose in line with Treasuries. but markets were nevertheless able to post positive returns... UK Germany Global US 2. 2. 2.9 4.. 8 9 9 8 27 days (t=: start of 3 Fed rate hike cycles since 994) Japan.3 2 3 4 average performance of government bonds (in % local currency) during 3 Fed rate hike cycles (since 994) US Treasuries (yield > y) German Bunds (yield > y) UK Gilts (yield > y) Japan JGBs (yield > y) Global government bond yields usually followed the lead of rising US interest rates. Source: Allianz Global Investors, Bloomberg Past performance is not a reliable indicator of future results, as of 3.7.24 Chart : Commodities as best performing asset class Commodities posted solid gains 2 with relative outperformance of industrial metals and energy 8 9 9 8 27 days (t=: start of Fed rate hike cycles since 987) Commodities Industrial metals () Energy (4) Commodities (all) (4) Precious metals (3) Agriculture ().8 3.3 2.2 33. 44. 2 3 4 average absolute performance (in %) of commodities during Fed rate hike cycles (since 987) Historically, rising central bank rates coincided with a strong surge of commodity prices. Number of cycles with positive absolute performance in brackets Source: Allianz Global Investors, Bloomberg Past performance is not a reliable indicator of future results., as of 3.7.24 9
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