Head of Equity Strategy
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). Bond. Long Bond(s)
With real rates being too positive, we see three scenarios: Opportunity to lock in rates at cycle high, government overreach to keep the economy afloat or a complete reset of the economy.
Steen Jakobsen,
Chief Investment Officer
Is a bond bull market ahead? Inflation still poses a risk for investors, but the moment for increasing duration to your portfolio may be approaching towards the end of the year, when central banks might be forced to cut interest rates.
Althea Spinozzi,
Senior Fixed Income Strategist
The furious rate hike cycle has brought gains in the US dollar, but with stagflation risks in Europe and the UK and weakness in the Chinese economy, USD may have more room to run. But a strong dollar could also have repercussions for US growth, emerging markets and commodity prices.
Charu Chanana,
Market Strategist
With the cost of capital rising painfully, stagflation fears are back, illuminating the fragile state of the green transformation, while giving a tailwind to nuclear power, and threatening the growth of AI-related stocks.
Peter Garnry,
Head of Equity Strategy
With supply tightness not only in energy but all commodities, the momentum in commodity prices may continue, pressuring central banks to lower real rates. That could be a good setup for precious metals, including gold, silver and potentially platinum as well.
Ole S. Hansen,
Head of Commodity Strategy
As the pandemic showed, even the US Treasury can experience seismic shifts. With the government increasing the pace of issuing bonds to support fiscal spending, the complex Treasury market and regulatory constraints could spark a liquidity event.
Redmond Wong,
Market Strategist
The tide has turned for bonds. Given the current yields, bonds have become an attractive investment, with added benefits including lower risk than stocks, increased diversification and a steady stream of income unaffected by economic changes.
Peter Siks,
Investment Coach
Disclaimer
The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website. This content is not intended to and does not change or expand on the execution-only service. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.
Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-gb/legal/disclaimer/saxo-disclaimer)
