Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Is this rate cycle different from history?
Peter Garnry
Chief Investment Strategist
Summary: Since 1973 rising effective Fed Funds Rate has been equal to statistically significant positive returns in equities both in absolute and relative terms. This is thus our prior as the Fed's rate hike cycle has begun, but a prior must be updated when new information arises. The critical thing this time around is that financial conditions have tighten a lot even before the rate cycle has begun, and thus we are likely to see financial conditions tightening to such high levels that equity returns will likely turn negative despite our prior. As a result we remain cautious and defensive with the recent rebound being an opportunity to position defensively again.
History suggests tightening Fed Funds Rate is positive
The equity market was remarkably comfortable yesterday despite Powell’s hawkish comments about hinting of going 50 bps at the May FOMC meeting and potentially another 50 bps in June and Brent crude rallying beyond $115/brl. We have gone from temporary inflation and average inflation targeting (allowing rates to remain above 2% for an extended period) to that of hiking until something breaks as we highlight in today’s Saxo Market Podcast. This increases the risk of recession and downward pressure on equities, but the equity market has not reached that conclusion yet with S&P 500 futures going up today.
As we showed last week, history suggests that rising effective Fed Funds Rate is positive for equity returns both nominal and in excess terms (subtracting bond returns). The effect is statistically significant with p-values below 1%. This indicates that when the Fed begin tightening rates it correlates well with a rapidly expanding economy and thus rising profits and positive lift in equity valuations. This has historically been the case and that should be your prior. In other words, the Fed’s expected trajectory is positive for equities. Now, in Bayesian statistics we update that prior when new evidence presents itself.
Financial conditions is key to understand the current rate regime
The current inflationary pressures are a complex mix of global supply constraints in logistics and manufacturing out of China, excess fiscal stimulus during the pandemic, a decade of underinvestment in metals and energy, and now the war in Ukraine. When inflationary pressures are driven by the supply-side of the economy and fiscal stimulus is still high then the only way for the central bank to ease inflationary pressures it to cool demand. This is what the Fed is planning to do quickly through hiking interest rates and tightening financial conditions.
Financial conditions have already tightened a lot recently without the Fed reducing its balance sheet or hiking the Fed Funds Rate (see chart). Since 1971 the correlation between financial conditions and the Fed Funds Rate has been 0.6, but since 2003 it has effectively been zero suggesting financial conditions are an entirely different thing compared to the past. This is crucial for updating the prior that the current hiking regime is good for equities.
With financial conditions already tightening before the aggressive rate hikes have begun (the low correlation at this point), the rate of change and level in which we will see in financial condition could be something we have not seen since the financial crisis in 2008 if the Fed hikes by 50 bps in May and June. The Chicago Fed Adjusted National Financial Conditions Index is right now at -0.25 which means that as of 11 March financial conditions in the US were still looser than average given economic activity. Date since 1973 suggests that as financial conditions move above 0.5 then it becomes a negative factor for equity returns and this is where it gets interesting vs the higher Fed Funds rate equals positive equity returns. If financial conditions tighten a lot as a function of many things including Fed hikes then this rate cycle will not be like the historical average, quite the contrary. Our concluding remarks are thus that we are still defensive and prefer equity themes that have momentum and will do well in the current regime (logistics, cyber security, defence, and commodity sector – we added green transformation to this group yesterday). Latest Market Insights
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