Equity markets sold off rapidly in February after an exceptional period of low volatility that saw stocks rise for fifteen straight months. The S&P 500 Index entered correction territory, down more than 10% from its late January high, and is yet to recover all its losses as of this writing. As of May 10th, the index has seen thirty-two 1% daily absolute moves in 2018, compared to just eight such moves in all of 2017, which gives some perspective on how volatility has jumped. We touched on this briefly in a separate piece on trader induced volatility and market corrections earlier this year.
The initial selloff in February came after a surge in interest rates that saw the yield on US ten-year treasury bonds rise from 2.40 to 2.90 over the first three weeks of the year, followed by an employment report on February 5th that showed wages growing 2.8 percent year-on-year in January. The wage report raised the specter of accelerating inflation and more aggressive Federal Reserve (Fed) policy in response.
Markets have remained choppy since then, even as uncertainty over the direction of monetary policy rises – the Fed is clearly tightening, but the question is how fast they will go. Of course, the ebb-and-flow of the White House’s trade related actions only adds to the noise.
UNCERTAINTY AROUND MONETARY POLICY HAS INCREASED
Policymakers raised rates by 25 basis points (bps) at the Fed’s March meeting, as was widely expected. They also appear to be on track to raise rates again at their June meeting, with the federal funds futures market putting a probability of 100% on that event. The current median projection by committee members is for three rate hikes in 2018, unchanged from their December 2017 view.
At the same time, there has been a clear and sharp tonal shift toward a more hawkish position. As economist, Tim Duy, pointed out , Federal Reserve Chairman Jerome Powell’s semiannual policy report to Congress at the end of February signaled a significant change of focus for the Fed. In a span of seven months, the policy objective shifted: from achieving maximum employment – to sustaining maximum employment – to avoid overheating the economy.
"The Committee continues to expect that the evolution of the economy will warrant gradual increases in the federal funds rate over time to achieve and maintain maximum employment and stable prices . ” – Janet Yellen, July 2017
"We continue to expect that gradual increases in the federal funds rate will be appropriate to sustain a healthy labor market and stabilize inflation around the FOMC’s 2 percent objective.” – Janet Yellen, November 2017
"In gauging the appropriate path for monetary policy over the next few years, the FOMC will continue to strike a balance between avoiding an overheated economy and bringing PCE inflation to 2 percent on a sustainable basis.” – Jerome Powell, February 2018
Excerpts of testimony by Federal Reserve Chairs Janet Yellen and Jerome Powell. Source: FedWatch .
As recently as November 2017, then Chair Janet Yellen maintained that the focus would be on sustaining a healthy labor market. However, Powell’s testimony, and various statements by other Fed officials since then, suggest that they are more worried about an overheating economy.
This shift, and the corresponding uncertainty surrounding its policy implications, can be seen in the futures market probability of four rate hikes in 2018. At the beginning of the year, the probability of at least four rate hikes in 2018 was close to 10%. In other words, markets were putting a 90% probability on the Fed sticking to their three rate hike projection. However, as the exhibit illustrates, the probability of four rate hikes is now close to being a coin flip, i.e. almost 50%.
Probability history of at least four rate hikes in 2018, based on 30-Day Fed Fund futures pricing data. Period: December 31 1, 2017 – May 7, 2018. Data source: CME FedWatch Tool .
On the face of it, four rate hikes instead of three is simply a matter of 25 bps and does not appear significant. Yet, with tepid wage growth and inflation rising (though still dominated by transitory factors ), the reality is real wage growth is decelerating. Unless wage growth picks up over the rest of the year, the question remains whether the economy is actually in danger of overheating. Recent inflation numbers also suggest that inflation may be getting close to the Fed’s target but there is no danger of acceleration.
As we noted in a previous piece , long-term nominal and real yields have climbed this year, but the yield curve has flattened thanks to rates at the short end of the curve rising even more. So bond markets have also started to become less optimistic about future growth.
IS 2018 SIMILAR TO THE TAPER TANTRUM IN 2013?
Rising rates as a result of the tightening of monetary policy, and the related sell-off in 2018 have prompted comparisons to the taper tantrum of 2013. The taper tantrum began on May 22nd 2013, when Fed Chair Ben Bernanke told Congress that the Federal Reserve might consider trimming its bond purchase program that year. Yields on ten-year US treasuries, which had already climbed almost 30 bps over the previous three weeks, surged another 66 bps over the next thirty five days. Equity markets also sold off, with the S&P 500 Index falling -5.76% between the day of Bernanke’s remarks and June 24th.
However, stocks recovered over the remainder of the year, with the S&P 500 Index seeing an overall return of 32.39% in 2013. Most importantly, the Fed did not trim its bond purchases at all that year (the process did not begin until October 2014). Bernanke convinced markets that even if tapering started the Fed would keep short-term interest rates near zero for a long period and not allow monetary conditions to tighten.
This is in sharp contrast to what the Fed is doing this year.
Another difference from 2018 is that the yield curve steepened significantly in 2013 as the economic growth outlook improved. The spread between yields on ten-year and two-year US treasuries climbed by 113 bps in 2013. In 2018, this spread has actually shrunk – from 51 bps at the end of 2017 to 43 bps as of May 10th.
So 2013 may be the wrong comparison year to draw from.
A SHORT HISTORY OF MONETARY POLICY ACTIONS AND FINANCIAL MARKETS
We looked at monetary policy actions between 1983 and 2017 to see what happens to financial markets when the Fed gets hawkish. As the exhibit below illustrates, there is no obvious correlation between equity market returns and monetary policy actions (we use the annual change in target federal funds rate to proxy this).
Years with the worst returns – like 2001, 2002 and 2008 – have coincided with significant easing by the Fed, which is not surprising since you would expect that in the midst of recessions.
Annual change in the target federal funds rate and S&P 500 Index total returns between 1983 and 2017. Data source: Federal Reserve , Morningstar.
What jumps out of the exhibit is the fact that over the last thirty five years, it is not often that the Fed has raised rates continuously over more than two calendar years i.e. you do not see too many upward pointing red arrows clustered together. Exceptions are the 2004-2006 rate hike cycle (which actually lasted exactly two years, from June 2004 to June 2006) and the current rate hike cycle (which began in December 2015).
While the Fed has proceeded very gradually this cycle, in the past they have gotten aggressive with tightening fairly quickly. Six out of the thirty five years saw the Fed raising the target federal funds rate by more than 100 bps, i.e. 1988, 1994, 2000, 2004, 2005 and 2006. The following table summarizes equity market returns and drawdowns, interest rate and yield curve moves and the key economic data in those years. Readers please note four of the six years saw an inverted yield curve and recession within a couple of years.
The simple average return for the S&P 500 Index across these six years (when the Fed increased rates by more 100 bps or more) is 6.67%, and the average maximum drawdown is -9.47%. However, these averages do not mean much since we have such a small sample of six years. As Jason Zweig, the Wall Street Journal’s investing commentator, puts it :
The future isn’t a single line you can extrapolate from the past.”
Instead of a purely quantitative approach, as is common when looking at monetary policy history, we find it more useful to look at what actually happened in each of these years as the rate hike cycle progressed, in the form of vignettes.
The Fed initiated a series of rate hikes after the first quarter of 1988 in a bid to fight rising inflation, with the federal funds rate eventually rising by about 300 bps. The core personal consumption expenditures (PCE) price index rose from 3.6 percent at end of 1987 to 4.6 percent by the end of 1988.
As the above exhibit illustrates, long-term interest rates also surged between March and August, with the ten-year yield rising 129 bps, from a low of 8.12 to a high of 9.41. This period also saw choppy markets, with a maximum peak to trough drawdown of -7.64% for the S&P 500 price index. Most of the index’s gain of 16.54% in 1988 came thanks to a rally over the last four months of the year (plus dividends), by which time interest rates were mostly moving sideways.
An aggressive Fed looking to ward off inflation by raising rates eventually ended with an inverted yield curve by December, even as the ten-year yield rose 31 bps over the course of the year. The economy went into a recession eighteen months later, in July 1990. John Carlson, an economist with the Cleveland Fed, noted that the Fed’s effort to fight inflation may have exacerbated a weakening economy.
The biggest difference between 1988 and 2018 is the lack of inflation currently, and the Fed is highly unlikely to embark on a similar series of rate hikes. Also real GDP growth in 1988 was 3.8 percent, compared to an expected 2.5 – 3 percent for 2018.
In February 1994, the Alan Greenspan led Fed surprised markets by raising rates for the first time since 1988 (by 25 bps). They eventually raised rates by a total of 250 bps across the year. This was ostensibly in response to an inflation scare that saw rapidly climbing long term interest rates at the end of 1993. The inflation scare passed, with average core PCE inflation falling from 2.7 percent in 1993 to 2.2 percent in 1994.
As the exhibit illustrates, interest rates started climbing in February, and the S&P 500 price Index saw a peak drawdown of -8.94% between February and April. Markets recovered over the next several months as yields stabilized but fell again in the final quarter of the year. The S&P 500 managed to eke out a gain of 1.33% in 1994, on the back of dividends.
The last quarter also saw a massive 75 bps rate hike by the Fed (on November 15th), which resulted in a rapidly flattening yield curve. The spread between ten-year and two-year yields collapsed to 9 bps but did not turn negative, and the next recession was more than six years away.
In addition to the taper tantrum of 2013, the current environment has also drawn frequent comparisons to 1994. This may be apt due to choppy markets coinciding with an initial surge in long-term yields and a more hawkish Fed. So it does hold a cautionary tale.
Even though core PCE inflation averaged only 1.3 percent in 1999, the Fed followed up a 75 bps rate hike in that year with another 100 bps of rate hikes over the first five months of 2000. The Fed raised rates even as markets were getting increasingly volatile, as they looked to curb excesses surrounding the technology bubble. Though it may have been too late.
The ten-year yield fell quite rapidly throughout the year as growth expectations collapsed – this is unlike what we have seen so far in 2018, or for that matter in 1994. The yield curve inverted early in the year, with the spread between ten-year and two-year yields going negative on February 2nd, the day on which the Fed raised the target federal funds rate from 5.50 to 5.75.
Equity markets stabilized for a few months after the rate hike cycle ended in May 2000. However, the last four months of the year saw stocks tumble as the technology bubble burst. The S&P 500 index fell -9.03% in 2000, followed by returns of -11.85% and -21.97% in 2001 and 2002, respectively. Note that real GDP grew 2.9 percent in 2000, and the recession began only in March 2001, twelve months after the yield curve first inverted.
The obvious contrast between 2000 and 2018 is the fact that current valuations do not appear to be as stretched as they were during the bubble. The current market does look to be overvalued, with the cyclically average P/E ratio for the S&P 500 index standing at 32.1 as of December 2017, but this is significantly lower than the corresponding value of 44.2 seen at the end of 1999.
The Fed began a new rate hike cycle in June 2004, well after the housing bubble was underway (in hindsight). A series of 25 bps rate hikes saw the target fed funds rate climb from 1 percent in June to 2.25 by December.
Even though core inflation remained close to the Fed’s 2 percent target, long-term interest rates saw a wild ride early in the year. The ten-year yield rose from as low as 3.70 in mid-March to a high of 4.85 by mid-May, i.e. a 115 bps rise in two months. This period coincided with a drawdown of more than -6% for the S&P 500 price index.
As the exhibit above shows, equities remained choppy until the end of the October, with year-to-date returns hovering close to zero. All of the S&P 500 Index’s 10.74% gain in 2004 came from a huge rally over the last two months of the year (plus dividends). Long-term interest rates had stabilized by this time, and despite all the tumult, ten-year yields ended 2004 only 3 bps lower than where it began.
We believe 2004 better resembles 2017, rather than 2018. As in 2004, last year saw the Fed finally embarking on a series of rate hikes after a halting start in 2015. Both years also saw significant yield curve flattening, but still some ways off from inversion. The spread between ten-year and two-year yields fell to 116 bps by the end of 2004, compared to 51 bps at the end of 2017. In both cases, almost all of this was due to significant upward movement at the short end of the yield curve.
The Fed followed its 2004 rate hikes with a series of continuous hikes throughout 2005 that saw the federal funds rate rise by 200 bps, even as inflation remained largely on target.
Long-term yields surged at the beginning of the year, with the ten-year yield climbing 64 bps between early February and the end of March, from 4.00 to 4.64. Surging interest rates combined with a couple of rate hikes in the first quarter saw the S&P 500 Index pull back more than 7% by mid-April – a scenario akin to what we saw in early 2018. Equities rallied in the second and third quarter as interest rates remained in a fairly tight range, though year-to-date gains were less than 3%.
As the above exhibit depicts, interest rates again climbed in September and October, coinciding with yet another pull back in equities. However, the last two months of the year saw long-term yields flatline and equities staging a rally, though not one nearly as powerful as the 2004 year-end rally. The S&P 500 Index gained just 4.83% in 2005, all of which came in November and December (plus dividends).
The yield curve inverted in December 2005, once again thanks to aggressive tightening by the Fed that sent the short end of the curve racing up. Ten-year yields ended up only 15 bps higher than where they started the year. The spread between ten-year and two-year yields fell from 116 bps at the beginning of 2005 to -0.02 at the end. Of course, the recession was still about two years away, and the economy expanded 3 percent in 2005.
2005 may be an apt comparison for 2018, solely from the point of view of where the rate hike cycle currently stands, i.e. right in the thick of it, with the Fed possibly looking to step up its pace. Markets can remain choppy under such conditions and yield curves can invert fairly quickly (though a recession may still be relatively far away).
Having covered 2004 and 2005 above, we do not believe there is much more to add about 2006, which saw the end of that rate hike cycle. The Fed raised rates by another 100 bps over the first six months of the year – the final rate hike in June coincided with the end of Alan Greenspan’s long tenure as Fed Chair.
The S&P 500 Index traded in a tight range over the first seven months of the year, hovering close to the zero level in terms of year-to-date gains. In addition to a hawkish Fed, this period also saw interest rates climb – the ten-year yield rose 60 bps during this time, from 4.39 to 4.99.
Equities staged a massive rally over the last five months of the year, with the S&P 500 Index ending 2006 with a 15.61% gain, as the new Ben Bernanke led Fed ended rate hikes. As the above exhibit illustrates, long-term yields also reversed course and fell during this period.
The yield curve remained inverted through most of the year, with the spread between ten-year and two-year yields only briefly rising to positive territory when the long-term yield surged. We all know what happened next – the recession began in December 2007, though equity markets continued to post new highs as late as October 2007.
Equities and interest rates ultimately follow idiosyncratic paths across the years, making exact comparisons difficult, not to mention other issues like trade and geopolitics that can temporarily drive markets. Yet some common themes emerge when looking at periods of aggressive Fed tightening actions over the past three and half decades.
Equities typically have been uncomfortable with surging interest rates, especially when it coincides with a more hawkish Fed. Years that saw restrictive monetary policy have mostly coincided with rising long-term yields, albeit temporarily, and volatile markets. At the same time, most of the equity market gains (which could be significant) have come during short bursts, which made timing these events really difficult.
Also, rate hike cycles simply have not lasted very long, perhaps because the Fed has come in late and had to move aggressively. The last three cycles seemed to follow a progression in five steps – we note that this is simply a very rough heuristic and comes with the immense benefit of hindsight:
1) The economy starts to really chug along and the Fed raises rates – we see a “bull flattening”, where the yield curve flattens and equities rally.
2) Subsequently, the Fed starts to get more hawkish, fearing an overheating economy.
3) Long-term yields surge even as the yield curve flattens, eventually inverting. Equity markets become volatile throughout this period, mostly moving sideways but with brief rallies, perhaps when there appears to be more policy certainty and yields stabilize.
4) The Fed pulls back and ends the hiking cycle – equities rally for a time while the economy continues to soften.
5) Economy goes into recession, equities fall and the Fed eases again.
The last three cycles have more or less followed this pattern despite very different recession drivers in each of them – the oil price shock induced by Iraq’s invasion of Kuwait and weaker consumer demand in 1990, the bursting of the technology bubble in 2001 and the housing crisis in 2008.
It may seem easy to guess where we are in the current cycle, but there is always a chance that this time really could be different. 2018 could end up looking like 1994, with a recession far out in the future.
We cannot help but end this piece with what Michael Lewis wrote in his book Panic: The Story of Modern Financial Insanity :
Everything, in retrospect, is obvious. But if everything were obvious, authors of histories of financial folly would be rich. They’d spare themselves the trouble of making their living writing books and articles about the financial folly and open hedge funds.
It’s never entirely obvious what is going on inside some boom. Not only does financial history seldom repeat itself; it seldom even rhymes. Financial markets work in free verse, and no matter how much you’ve studied them — no matter how many times you’ve read Charles MacKay’s Extraordinary Popular Delusions and the Madness of Crowds — you remain at risk of being sucked into the passions of the moment.”