ARTICLES
Don't Fight the Fed
By Vasco Laranjo, CFA
There is a mantra in the investment community that goes by “Don’t Fight the Fed”. It suggests that investors should align their decisions with those taken by the Fed, and more specifically the Federal Open Market Committee (FOMC), regarding reference rates. At the moment we are experiencing the fastest Fed Rate Hiking Cycle ever, as described in the previous article, and the S&P 500 Index is close to 15% below its early 2022 all-time high it seems prudent to live by this mantra. But was it always like this? In this article, I will explore how the S&P 500 Index behaved during previous reference rate hiking and cutting cycles.
The State of the Current Fed Reference Rate Cycle
Following a troubling beginning of March that brought back frightening memories of the Great Financial Crisis, it seems like things have calmed down now in the markets with the Fed raising reference rates in March and the Fed Funds rate futures pricing in another hike (of 25 basis points) in May. 1 Moreover, after March’s inflation (CPI) print the futures show that market participants expect that the Fed will already start cutting rates at the beginning of the third quarter of this year, in the July meeting. Following that, consecutive rate cuts are expected with a reduction in reference rates on the order of 200 basis points by September 2024. With a continuously strong labor market and stubbornly high inflation in the US, well above the 2% Fed target, only time will tell how those bets will play out.
The chart below shows the actual historical Fed Funds Target rate and the future Fed Reference rate as implied by the Fed Reference rate futures until September 2024.2
Having that in mind, I believe it might be interesting to take a look at how the market, as measured by the S&P 500 Index, behaved in previous reference rate hiking and cutting cycles. So, in the next two sections, we will first look at the market performance during previous Fed rate hiking cycles, and then cutting cycles.
Fed Reference Rate Hiking Cycle and Market Performance
Keeping the same methodology used in the previous article, I defined that the hiking cycle starts at the time of the first reference rate increase, and it finishes when more than two interest rate cuts are implemented. Also, for it to be considered a cycle there must be more than one interest rate hike.3
As we can see in the chart above, the current Fed hiking cycle has made the “Don’t Fight the Fed” mantra live up to its name. Pursuing the first couple of rate hikes, the market has been having trouble coming back to positive territory and is currently about 15% below the value at the start of the monetary tightening campaign last year. We can see that at the beginning of most of the previous hiking cycles the market had trouble finding a direction as most of the time it drifted close to the 100-line.
Nevertheless, in some occurrences one year after the first reference rate hike the market started to gain traction on the positive side and then trended higher. Still, that can hardly be said to be a consensus with the huge crash of 1987 or the 1999-2000 and 1983-1984 cycles. Given that, it might be indeed prudent to take note of the mantra and not invest in the market when the Fed is raising interest rates.
Having seen how the market reacts during periods of monetary tightening, it is now time to move on and see its behavior during monetary easing.
Fed Reference Rate Cutting Cycle and Market Performance
For the sake of simplicity in defining the Fed reference rate cutting cycle, I considered those cycles to be the remaining dates in the timeframe, that is, when we were not in the “hiking cycle” regime. I believe that, in the end, this may be a relatively prudent approach to avoid falling into the hindsight bias trap. Note that it is currently much easier to say when a cycle came to an end than it was at the time the cycle was still running. Having that said, we can move on to the analysis of the Fed reference rate cutting cycle and the market performance.
Similar to what we saw in the previous chart, during the Fed rate cutting cycles we do not see any clear up or down trend in market performance. To begin with, it is important to note that, typically, the Fed reduces reference rates in expectation of a future economic downturn. Therefore, the start of the rate cutting cycle may coincide with or precede the beginning of a recession, which is the case of the 2000-2004 and 2007-2015 cycles that we see in the chart above. During those times, it would be unwise to follow the Fed and invest in the market right away. Probably a cleverer approach would be to wait for the Fed to stop cutting reference rates and then start investing in the market. That was particularly true in those before-mentioned cycles, as we can see a strong market recovery once the Fed slowed the pace of rate cuts.
Yet, it is again easier to see that now than at the time since we probably would not have known when the Fed would start reducing the pace of rate cuts – unless there was clear forward guidance from the FOMC. Finally, we see that the 1995-1999 cycle also showed some of that trend with a stellar recovery after the last round of rate cuts at the end of the cycle.
Final Note
Every cycle is different, be it hiking or cutting. However, it appears that stocks tend to perform better once the rate decisions are coming to an end or at least following a smoother pattern. Also, curiously it looks like the market almost always found a way to climb to higher levels, in both environments. This is in line with another saying that goes by “Stocks Always Go Up”. While that has been true over the long term, it is not the case for shorter periods – just take a look at the 2000s decade. All in all, it looks like it is prudent not to fight the Fed, but what seems to be trickier is to time the market…
1 Based on CME FedWatch Tool’s Meeting Probabilities. More information can be found on the CME FedWatch Tool website here
2 Note that the FOMC funds rate targeting started in October 1982 as outlined in this working paper. Moreover, in 2008 the FOMC switched its process from rate targeting to rate range targeting with a lower and upper limit. Accordingly, for the purpose of this article, I linked the Federal Funds Target Rate (until 2008) with the Federal Funds Target Range - Lower Limit (from 2008). For the Fed Funds Futured-implied rate, the Lower Limit was also used. The rate used for the Fed Funds Futured-implied rate for every future month was that with the highest probability in the CME FedWatch Tool’s Meeting Probabilities table.
3 These rules were put in place to accommodate for 1983-1984 to be one cycle and to distinguish the 1987 cycle from 1988-1989.
Sources
Data Source:
FRED , Board of Governors of the Federal Reserve System (US), retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/
Code Source: GitHub Page
Cover Image Credits: © snow0810/ ID: 6060114798/ Flickr.com
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