High dividend stocks and exchange - traded funds are often thought to be vulnerable when the Federal Reserve embarks upon
rate tightening cycles.
Our view that the Canadian interest
rate tightening cycle will lag that in the United States is therefore primarily the result of factors outside of the respective business cycles.
In other words, the market's return has actually been sub-par for a reasonably long period following the final hike of
a rate tightening cycle.
Not exact matches
The somewhat stronger U.S. inflation signal implies a modestly more hawkish U.S. Federal Reserve
tightening cycle than what we would expect to see out of the Bank of Canada (BoC) after it left its key overnight lending
rate unchanged at 1 % this month.
Rather than a traditional offsetting relationship at this early point of the
tightening cycle, the near - term interest
rate outlook and the near - term profits outlook are both negative.
The question lingering on investors» minds is how many
rate increases the central bank intends to implement until the end of the
tightening cycle, and if it was willing to raise
rates above it its so - called neutral
rate.
Also, bills have typically traded below other money market
rates during
tightening cycles, as they do now; periods where bills trade at or above other
rates have been the exception and not the rule.36 Thus, the smaller increase in bill yields than in
rates on other term instruments is not surprising, and I do not read it as undermining the general conclusion that the policy
rate increase was effective in firming money market conditions.37
During this
cycle of monetary
tightening, the fed funds
rate — the
rate controlled by the Fed to influence borrowing costs — has been raised four times.
Fed has hiked 14 times and 10 yr
rates are unchanged while 30 yr
rates are 60bp lower than at the beginning of the
tightening cycle.
In some ways, this U.S. policy
rate hike
cycle is similar to the one in the mid-2000s, where the U.S. dollar remained weak and EMs» growth
cycle was not derailed by U.S. monetary
tightening.
The pace of
rate increases has picked up since the central bank began its
tightening cycle in December 2015.
In previous episodes, long yields tended to rise in the early stages of a
tightening cycle at least as much as the rise in short
rates, reflecting inflation concerns.
After increasing their policy
rates by 125 basis points and 150 basis points respectively in the current
cycle, market participants expect that the
tightening cycles in both the UK and New Zealand are close to an end, although in both cases, recent inflation data have caused some participants to revise that assessment.
Now, as I noted fairly early this year, there's no statistical evidence at all that stock prices or corporate earnings perform well in the 18 months or so following the end of a
rate -
tightening cycle.
That would be a relatively low level by historical standards; in the past two
tightening cycles by the Fed, the federal funds
rate peaked at around 6 per cent.
Since the beginning of its current
tightening cycle in June 2004, the federal funds
rate has been increased from 1.0 per cent to 2.5 per cent in increments of 25 basis points at each Federal Open Market Committee (FOMC) meeting.
Implied volatilities gradually declined around the world in the second half of 2003, as it became clearer that the easing
cycle was drawing to a close, with some central banks beginning to
tighten monetary policy after a prolonged period of relatively low and stable interest
rates.
Fed Chair Janet Yellen last week signaled the U.S. central bank is on track to raise
rates this year, despite a weak first quarter that some analysts believe could force the Fed to wait longer before starting its first
tightening cycle since 2004 - 2006.
Indeed, I believe the Fed will raise
rates in a slow manner that doesn't excessively unsettle the economy or markets, with the gradual nature of the
tightening cycle allowing markets to absorb the increases with relative ease.
Our interest
rate outlook is also partly driven by the view that the BoC intentionally wants to lag the Fed in terms of its
tightening cycle.
With the unemployment
rate down to five percent and the Fed embarked on a
tightening cycle, the argument runs, indicators will start returning to earlier, higher growth trends.
«While the Fed is moving in one direction and getting ready to raise interest
rates and embark on a
tightening cycle, the European Central Bank is going in the other direction and easing monetary policy,» says Eric Viloria, a currency strategist at Wells Fargo in New York.
While the Fed is moving in one direction and getting ready to raise interest
rates and embark on a
tightening cycle, the European Central Bank is going in the other direction and easing monetary policy.
When the Fed does get closer to its dot - plot
tightening cycle for short - term interest
rates, I'll be there backing up the truck.
One more note: I believe gradualism is almost required in Fed
tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short
rates like three - month LIBOR, which correlates tightly with fed funds.
The Reserve Bank of New Zealand raised its target
rate by 25 basis points to 6.75 per cent in March, taking the cumulative increase since this
tightening cycle began in early 2004 to 175 basis points.
While the Fed has verbally committed to a shallow and short
tightening cycle, interest
rates are still likely to rise.
Fed
tightening cycles often start with a small explosion where short - dated financing for thinly capitalized speculators evaporates, because of the anticipation of higher financing
rates.
However, the index had positive cumulative returns (2.64 % and 63.66 %) during the other two
tightening cycles, during which
rate increases were fairly steady over time.
Interest
rate - hiking
cycles were measured by Fed
tightening cycles.
During 2004 a leading quantitative analyst predicted the the market multiple on the S&P 500 stocks would decline as interest
rates increased, reflecting the Fed's
tightening cycle.
If you look at periods where the price / peak earnings multiple was 16 or higher on the S&P 500, the final
rate hike of a
tightening cycle was actually associated with losses on an annualized total return basis, averaging -7.18 % over the following 6 months, -9.94 % over the following 12 months, and -5.87 % over the following 18 months.
We expect the current
tightening cycle will be steady and gradual, likely resulting in four hikes in 2018 and two or three hikes in 2019 until
rates reach 3 % to 3.25 %.
They can engage in fancy strategies where they try to remove policy accommodation either through
rates or the size of the balance sheet, but one thing Fed history teaches us is that the Fed doesn't know what will happen when a
tightening cycle starts, but usually it ends with a bang — some market blowing up.
That works well when interest
rates are falling, or when the FOMC is on hold at the bottom of the
cycle, but once the hint that the first
tightening might occur, it doesn't work well until the first loosening is hinted.
One more note: I believe gradualism is almost required in Fed
tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short
rates like three - month LIBOR, which correlates tightly with fed funds.
This means that as the central bank undergoes a
tightening cycle, it could be beneficial to trade interest
rate risk for credit risk, if one believes in the continuing strength of an economy.
But
tightening the Fed funds
rate is not easy, particularly toward the end of the
cycle.