By Gargi Pai Chaudhuri
- We believe this latest Fed hike may be the last hike of the current cycle.
- A slowing economy, moderating inflation and stress in the banking system support a Fed pause. But we expect the Fed to keep rates at current levels for an extended period as inflation remains well above its 2% target.
- History suggests investors may be rewarded when stepping out of cash and moving into investment grade fixed income and equity exposures when the fed stops raising rates.
As broadly expected, the Federal Reserve raised the policy rate by 25 basis points (0.25%) at its May 3 meeting. While the Fed did not commit to a pause, markets are overwhelmingly convinced — barring a dramatic change in the economic data or an exogenous shock – that this latest hike was the last hike of the cycle. From the statement, we now know the Committee no longer sees that “some additional policy firming” is needed. This is not the first time that the market has concluded that the Fed was set to ease and up until this point we have stubbornly argued the notion that the Fed had would keep hiking counter high and persistent inflation. This time, however, we find ourselves broadly in agreement that the time for the pause has finally arrived.
3 REASONS THE FED IS LIKELY TO PAUSE
Here are three reasons we think this time is different, and the Fed will pause its tightening cycle:
- Recent data suggest growth has slowed and inflation has moderated. While price pressures have not eased enough to justify rate cuts, a pause at current levels no longer seems unreasonable;
- Policy rates have finally risen to levels consistent with Federal Reserve guidance. A 25 basis point hike at the May FOMC brings the policy rate range to 5.00–5.25%, squarely in line with the median 2023 “dot plot” in the FOMC’s latest Summary of Economic Projections; and
- Banking system stress has tightened financial conditions. Tighter bank lending standards can obviate the need for further policy rate hikes.
Importantly, a Fed Pause is not the same as a Fed Pivot.
A pause is a period where the Fed keeps rates “higher” and monitors the development of the economy and inflation. In the five previous hiking cycles since 1990, the Fed paused an average of 10 months between its last hike and its first cut (Figure 1). Even though this hiking cycle was incredibly fast relative to history, we expect the pause to be more in line with historic averages.
WHAT A FED PAUSE MAY MEAN FOR PORTFOLIOS
With attractive money market and ultra-short term bond yields, investors have been finding shelter in cash and cash alternatives in the past 12 months, especially around the regional bank volatility in March. (1) However, as we reach the potential end of the Fed hiking cycle, it’s important to remember that sitting on too much cash, even in an ultra-short duration fund, can be costly; while investors can help avoid large market drawdowns with large cash allocations, investors on the sidelines have the potential to miss market swings to the upside.
Low risk solutions such as money market funds and short-duration Treasury ETFs can offer potentially attractive income, but historical data shows that cash exposures return less on average than core bond and short-term bond exposures when the Fed stops hiking interest rates (2) (Figure 1). On average, between 1990 and February 2023 core bond exposures performed 4% better than cash alternatives when the Fed held or dropped rates. Similarly, investment grade short-term bonds performed 1.9% better than cash in the same environment. (3)
Figure 1: Bloomberg US Aggregate vs. cash-alternative total returns after the last rate hike
Chart description: Bar chart depicting the total return (%) for the Bloomberg US Agg and cash-alternatives in the past five rate hiking cycles (1995, 1997, 2000, 2006, and 2018). The chart shows 3 month returns, and 12 month returns. For each cycle, the Bloomberg US Agg had higher total returns in both timeframes.
As data begins to show slowing activity in the U.S. economy, we also think it’s important to think about where investors might add ballast in their portfolio. We believe investors may want to consider stepping into high-quality medium-term fixed income — bonds maturing between 3–7 years — through exposure to the broader U.S. bond market. Not only can investors seek ballast, current Bloomberg US Aggregate Index (Agg) yields provide potential cushion where investors can still see positive returns even if bond yields rise, driving bond prices lower. Currently, the yield for U.S. 10-Year Treasuries could rise about 72 basis points (0.72%) before total return on the Agg turns negative.(4)
With persistently high inflation pressure, we continue to emphasize quality in stock portfolios, as rates could remain relatively firm during the pause period. Growth companies with a strong quality tilt — characterized by high returns on capital, margin stability and solid balance sheets with reasonable valuations — have tended to outperform in a late cycle environment with tight financial conditions.(5) Investors may look into both U.S. quality factor and international quality factor exposures to add quality into their portfolios.
Given the positive performance of the equity markets this year, despite slowing earnings growth and possibility of a recession, we believe markets will remain range bound and upside from today’s valuations may be limited. Investors can potentially weather the storm by staying allocated to defensive strategies such as minimum volatility. Min vol has historically lowered risk in portfolios. In fact, MSCI USA Minimum Volatility Index has had ~18% less volatility than the S&P 500 Index since inception.(6) Investors can use minimum volatility strategies to provide ballast in their portfolios and allow them to stay invested during periods of market turmoil.
Past performance is no guarantee of future results, of course, but historically both domestic equity and fixed income markets have posted higher returns three months after the Fed’s last rate hike. And alternatively, investors may consider alternative assets like gold. Although gold is a non-yielding asset, a tactical allocation may make sense for some investors in an environment of falling real rates, a weaker dollar and as a hedge against potential shocks.
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1 Source: BlackRock, Bloomberg, as of May 1, 2023. Flow into cash and cash-like alternatives from EPFR.
2 Source: Bloomberg, 1/1/1990 through 2/28/2023. Core bonds defined as Bloomberg US Aggregate Bond Index, investment grade short-term bonds defined as Bloomberg US Aggregate 1-3 Year Index, cash defined as Bloomberg US Treasury Bill 1-3M.
3 Source: Bloomberg, 1/1/1990 through 2/28/2023. Core bonds defined as Bloomberg US Aggregate Bond Index, investment grade short-term bonds defined as Bloomberg US Aggregate 1-3 Year Index, cash defined as Bloomberg US Treasury Bill 1–3M. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
4 Source: Bloomberg, as of April 25, 2023. The Agg represented by the Bloomberg US Agg Total Return Value Unhedged USD Index (LBUSTRUU Index).
5 Source: "Demonstrating factor cyclicality" chart.
6 Source: Bloomberg, as of May 5, 2023. MSCI USA Minimum Volatility Index incepted June 02, 2008.
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