Interest Rate Cycles – “The WayBack Machine: 1994”
Global risk asset markets continue to move wildly and trend lower as investors wrestle with the speed at which global Central Banks are raising interest rates and more importantly with the speed at which our Federal Reserve is shocking markets with its multiple 75 basis point rate increases as economic growth grinds to a crawl globally.
Last week, the Bank of England, in order to both defend the British pound and stave off a pension liquidity crisis, made an emergency intervention announcing it would buy as much government debt as needed to restore stability to currency and bond markets.
In layman’s terms, UK’s central bank pivoted back to QE, quantitative easing. So that’s three central banks back on the QE trail again, the UK, Japan, and Korea. 2022 has been no fun for investors outside of a few macro hedge funds.
Still, we have seen a few of these moves by Central bankers affecting currencies and financial markets like this in past cycles. “When,” you ask. Stay tuned.
I am Chris Perras with Oak Harvest Financial Group in Houston, Texas, and welcome to our weekly stock talk podcast, keeping you connected to your money.
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While Powell has repeatedly said that the Fed and its committee are “data dependent,” the government data they review continues to show elevated and stubborn inflation.
The Fed tends to rely on data collected by the Bureau of Labor and Statistics, which has historically lagged what’s going on in the real-time economy by months and quarters, both on the way up and on the way down. Powell’s words out of the September FOMC were more hawkish than markets were expecting, much as Alan Greenspan’s words were in 1994.
- The FOMC’s talk suggests another 75bps and 50 bps in hikes this year, taking the monetary policy into a very restrictive place.
- They have already raised rates three times in the last five months by seventy-five basis points at a time.
Check out the chart on how fast the Fed is raising rates vs. prior cycles. In the previous 40 years, only Greenspan in 1994 comes close.
In fact, outside the end of the Volcker years in the 1970s, the Fed has been raising short-term rates faster than at any point in the last 70 years. Only 1994 comes close when they doubled by 300 basis points in 12 months. Putting this in perspective, the pace of interest rate change is about the same but opposite direction as how fast the Fed cut rates in the wake of the Great Financial Crisis in 2008.
This notable comparison to 1994 led me to research what happened to financial markets in 1994. So, I went into the way back machine on the internet and Bloomberg and came up with this. Not surprisingly, the path, not magnitude, of both stocks and bonds, year to date, looks remarkably like 1994. 2022 is mirroring 1994, Right down to the currency crisis now happening in Europe.
Take a look at the chart of the SP500 throughout 1994, a period when Fed Chairman Alan Greenspan was preemptive to combat inflation, raising interest rates from 3% to 6% by the first quarter of 1995.
This included his 75-basis point raise in November 1994, which marked the peak in Fed hawkishness for that cycle. The 75-basis point move didn’t mark the peak in the Feds interest rate moves and its path to 6% in the 1st quarter of 1995, but it was the peak in the momentum of them raising rates.
As one can see by the chart, the stock market troughed and started heading higher at this point of peak hawkishness in the fourth quarter of 1994. The markets were already heading up and to the right well before Greenspan “pivoted” to the notion of possibly cutting rates in the second half of 1995. The markets were most interested in the rate of change in monetary policy. “When the Fed slowed, the markets saw “go.
Whether that was because something in the financial markets broke back in the winter of 1994, no one can say for sure. Greenspan’s tightening cycle sparked the Mexican currency crisis in December of 1994, nicknamed the “Tequila Crisis.” Are Chairman Powell’s aggressive Fed actions and our current Fed policy doing the same now with the breaking of the British pound in the last few months? Take a look at the year-to-date chart of the British pound. It has been trading like an emerging market’s currency this year.
Why does this happen, you might ask? Well, as the Fed increases US interest rates, there is a reduction in capital flows into other foreign countries. Money finds its way back to the US from foreign shores. As this happens, the demand for dollars increases, and the demand for foreign currency declines. Investors find US assets more attractive than offshore ones.
Taking a Look Back:
Looking back again at the SP500 chart from 1994, one will see by the late 4th quarter of 1994, the S&P500 had roundtripped two years of gains bringing it back to flat from the fourth quarter of 1992 through the fourth quarter of 1994. Likewise, this year the Fed’s aggressive rate path has taken the S&P500 index almost back to flat for the last two years in price and time. Just look at that chart. Unfortunately, this seems to be a very common theme when the Fed has been in an interest rate hiking cycle. That is the S&P500 roundtripping most of its 2-year gains before troughing and finding a move higher.
Remember, these Federal reserve monetary policies work with a lag both on the way up and down. The stimulative Covid responses in the second quarter of 2020 took 6 to 9 months to work their way into the economy. That’s even though the stock market had already anticipated its effects. Stocks moved broadly and sharply higher into the 1st quarter of 2021 in advance of the economic recovery. Small-cap stocks and most cyclical groups led the first nine months of the Covid recovery.
Likewise, the broad stock markets have moved down throughout 2022 in front of the Fed’s monetary policy tightening and its economic effects. The worst-performing groups have been the cyclical stocks that first led the move up in the second half of 2020.
They are the ones that retrospectively had the earliest and most significant demand boost and pull forward in sales. In 2022, most of these same groups have anticipated slow to negative economic growth in the first half of 2022 against near-impossible comparable growth in the first half of 2021.
Our Fed is taking the current inflation problem deathly seriously with these 75bps rate hikes, trying to make sure inflation doesn’t become a fixture in our future economy. One where consumers and businesses expect prices to rise in the future.
The real-time markets see inflation fears and risks subsiding, take a look at the chart of 2 real-time two-year inflation breakeven expectations for the last ten years. As you can see, it peaked near 5% in March and has come crashing back down below 2% in the last six months back into its historical range for the last ten years.
- Unfortunately, asset investors are afraid the Fed still doesn’t care about this real-time data and is set on a path of causing a recession to meet their inflation-fighting goals.
- The main cause for the broad downturn across all assets, including commodities year to date, isn’t the market’s expectation of higher inflation but rather higher real interest rate yields, the second component of interest rates.
Does the Fed want to throw our economy into a recession to tame inflation? Inflation that, by all accounts, they created much of by staying too easy with their own monetary policy in 2021. And the parts of inflation they don’t control, like commodities and energy prices, are already falling fast out of their control? I don’t know. That seems draconian to me, but I don’t run the Fed. Unfortunately, the Fed is still focusing on slower BLS data series.
What I do believe is that as soon as the markets feel that the Fed sees the pace of inflation slowing, which points toward the fourth quarter of 2022 in the BLS data, this will likely lead to a collective exhale of relief by investors across stocks, bonds, commodities and real estate, and a retreat in market volatility around almost all asset classes. Much as we saw from mid-June through Mid-August, a collective exhale would likely cause a collapse of future volatility expectations, calmer markets, and a significant upward rally in stocks.
Investor sentiment is now bordering on somber. The investor sentiment data, regardless of how it’s measured, is almost universally at lows not seen since the dot.com bubble burst or the Great Financial Crises lows.
The impacts from recent Fed rate hikes are being quickly passed on to the financial markets and other markets such as the housing market and other credit markets such as junk bonds. Unfortunately, areas of the economy that the Fed is watching, such as jobs and wages, have yet to feel the full impact of these aggressive rate hikes.
Listen, they will be impacted. As the Fed says, Monetary policy actions tend to influence economic activity, employment, and prices with a long and variable lag. Since Jackson Hole, the Fed has been using harsh rhetoric and forward guidance because they know it can immediately affect financial markets and the economy without a lag. Unfortunately, that brings about higher market volatility that few longer-term investors who are not traders enjoy.
When will this downturn in stocks end? No one knows for sure, but it has historically happened during periods of max pessimism and months, if not quarters before the data gets better and people call the coast is clear.
Two data series to watch for an early positive indication?
- A peak in the US dollar.
- A peaking in real interest rates.
To put the importance of the Dollar into perspective, here’s a chart of the Dollar from Allstar charts showing the Dollar versus its own volatility.
Recall that extreme volatility in both directions, up and down, is commonly found near inflection points. The last time the US Dollar Index had a single-day gain as large as Friday’s Sept 23rd was on March 19, 2020.
Summing It All Up:
The last time the US Dollar Index had a single-day loss as large as Wednesday, Sept 28th was on March 26, 2020. That was into the Covid bottom in the first quarter of 2020. The Dollar Index “DXY” peaked on March 20, 2020. Stocks bottomed the next week. Is the Dollar trying to tell us the downturn is nearly complete? I don’t know, time will tell, but it is a hopeful indicator behind the scenes.
Unlike the data the Fed is watching, market Inflation expectations looked to have already peaked months ago. However, the markets are still waiting and in uncertainty mode until the Fed slows its pace.
If the ongoing market volatility is making you feel uneasy, give us a call, and schedule a meeting with an Oak Harvest advisor. Our team does have insurance-based tools that do not have the volatility of public markets. However, we remind you that these investments may also have lower long-term expected returns
At Oak harvest, we think our clients are best served by us helping them plan for their future needs, instead of focusing on the past. The future and stock markets are always uncertain and that is why our retirement planning teams plan for your retirement needs first, and your greed second.
Give us a call to speak to an advisor and let us help you craft a financial plan that helps you meet your retirement goals. Call us here at (877) 896-0040 and schedule an advisor consultation. We are here to help you on your financial journey into and through your retirement years.
-I’m Chris Perras and from everyone here at Oak Harvest Financial Group, Have a blessed Weekend.
CFA®, CLU®, ChFC®
Chief Investment Officer, Financial Advisor
Chris is a seasoned investment professional with over 25 years of experience working with some of the most successful money management firms in the world. Chris has made it a point in his career to adapt as the market landscape changes, seeking to utilize the appropriate investment strategy for a given market environment. His transition from managing billions of dollars at the institutional level to helping individuals and families retire is guided by a desire to see first-hand the impact he is making in the lives of clients at Oak Harvest.