How to prepare for more aggressive policy from the US Federal Reserve

The new Chair of the US Federal Reserve, Jay Powell, is starting to make his first public pronouncements. His preferred narrative seems to be that the US economy is getting stronger and that tighter monetary policy is required. The US central bank therefore seems determined to continue to reduce the size of its balance sheet as per the timeline outlined in June 2017 by then-Chair Janet Yellen.

The Fed will start to reduce QE by $50 billion a month (or a $600 billion-a-year run-rate) later this year

Source: FRED – St. Louis Federal Reserve database. Reduction trajectory based on guidance given by US Federal Reserve in June 2017.

The Fed also seems on track to push through three more interest rate increases of one-quarter point each, starting with its next meeting on 20-21 March, although Powell’s narrative has markets wondering whether a fourth hike, or even a 0.5% increment, could be coming.

The Fed is expected to take interest rates from 1.50% to 2.25% in 2018

Source: CME Fedwatch

But perhaps Powell’s most important comment of all, thus far, came before he took on the top job at the world’s most powerful central bank and it is one picked up by Gillian Tett of the Financial Times newspaper. In a panel discussion at a meeting of the American Finance Association in Chicago in January 2017, Powell stated quite bluntly: “It is not the Fed’s job to stop people from losing, or making, money.”

This is a marked change from recent years, when the Greenspan, Bernanke and Yellen Fed paid great attention to securities prices and were seen as willing to back-stop markets with liquidity in times of crisis.

The new Fed Chair’s thoughts instead hark back to a different era, namely 1994, when Alan Greenspan stunned markets with a quick-fire series of interest rate hikes which took the Fed Funds rate from 3% to 5.5%.

That roiled stock and bond markets in the USA and the world over, even playing a role in the 1994-95 Mexican financial crisis, as higher US interest rates sucked cash out of Mexico, breaking the peso’s peg to the dollar and forcing a devaluation and then interest rate hikes which helped to tip the local economy into a recession so deep that America and the International Monetary Fund swiftly organised a $50 billion bail-out programme.

History is by no means guaranteed to repeat itself but it may be worth revisiting 1994 to see which asset classes and portfolio strategies worked best until markets found their footing again in 1995.

Back to 1994

This is how the Fed’s policy pivot looked.

The Fed moved harder and faster than anyone expected in 1994

Source: Thomson Reuters Datastream.

This is how American and British stock indices responded. Both took a swan dive initially, even if the move was not quite as violent as that seen in early February of this year.

UK stocks took offence even though the Bank of England cut interest rates by 0.25% to 5.13% in February 1994, as the Old Lady of Threadneedle Street then followed through with a pair of 50 basis-point increases to take the base rate to 6.13% by year end.

UK and US-quoted stocks failed to make much progress in the face of this policy tightening

Source: Thomson Reuters Datastream.

And this is how the price of US and UK benchmark 10-year Treasuries and Gilts took the news (remembering that the prices move inversely to yields). The violent plunge in the US Government bond market led directly to a huge trading loss at then-leading investment bank Kidder Peabody (and the unearthing of fraudulent trades by Joe Jett) and the bankruptcy of Orange County, California after its investment portfolio, run by Robert Citron, came unstuck.

UK and US Government bonds also struggled to make gains

Source: Thomson Reuters Datastream.

In sum, there were few places to hide. This next table compares the capital returns in local currency from a selection of key equity, bond and commodity indices, while also looking at some individual currency baskets and commodities for good measure:

Capital returns from key asset classes and indices in 1994

Source: Thomson Reuters Datastream.

Lessons to learn

The key conclusions from 1994 are therefore as follows.

  • Stocks did less badly than bonds
  • High yield debt was a disaster
  • Developed equity markets did less badly than emerging ones, although Asia did well and Japan did best of all in the equity arena
  • Commodities did well overall, perhaps buoyed by the economic upturn which central banks were seeking to cool, although the havens of gold and silver fared poorly

The tricky bit is that history is by no means guaranteed to repeat itself or be an accurate guide this time around, although at least advisers and clients can draw succour from how stocks and bonds regained their poise and marched powerfully higher from 1995 to 2000, albeit with some turmoil caused by the Asian and Russian debt crises of 1997-98 in between.

That was because US (and global) GDP growth held up well, inflation stood in the mid-single digits and corporate profit growth remained robust.

The backcloth was therefore supportive for security prices.

Whether the environment is quite so helpful today remains a matter of debate, with growth below tepid (despite gathering hopes for a globally synchronised recovery), inflation below target and global indebtedness higher than ever. The increase in debt in particular means the world will surely be more sensitive to even minor shifts in interest rates, so it may not take a 250 basis point cumulative increase in the US to cause some problems.

That said, if the Fed does stick to the three-hike script for 2018, that would take the total number of rate hikes to eight for this up-cycle since December 2015, or 200 basis points in total.

As this column has discussed before, that takes us right up to the post-1970 average of eight-to-nine rate hikes in a tightening cycle that has eventually stopped US stocks in their tracks, although the range across the eight individual samples is very wide.

Since 1970 it has taken an average of eight to nine Fed rate hikes to stop US stocks in their tracks

Source: Thomson Reuters Datastream

Contrarian case

For all of the talk of a tougher Fed, and Powell’s (correct) view that the central bank’s job is not to worry about markets, forward-thinking advisers and clients might start to look at what could make the Federal Reserve take a less strident line.

Under the Bernanke and Yellen regimes, QE-2, Operation Twist and QE-3 were launched after a 15% to 20% drop in the US equity market, a move lower in the ISM manufacturing sentiment survey (or purchasing managers’ index) or a sell-off in the junk bond market (or a combination of all three).

Recent Fed moves to loosen monetary policy have come after a fall in the US stock market ...

Source: Thomson Reuters Datastream

... a weakening of sentiment among manufacturers ....

Source: Thomson Reuters Datastream, Institute for Supply Management

.... and/or higher junk bond yields

Source: Thomson Reuters Datastream

The first real test of the Powell era could therefore come if we get a repeat – and junk bonds are already under pressure (as per the 1994 script), the S&P 500 has come off the top (although not by 20%) and the ISM industrial sentiment indicator has weakened, if only by a little.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.