Markets have been obsessed with the Fed's plans for rate increases and general liquidity withdrawals designed to somehow, even incrementally, just a little bit, ever so slightly, coax markets off their addiction to ultra-loose money. VIEW thinks there are two potential scenarios that have the highest probabilities going forward. One, given the central banks will have firmly addicted the patient (and the doctor) to unheard of levels of support and we will likely not reduce debt levels significantly below 100% of GDP any time soon, rates will not rise to anywhere near historical levels for commensurate inflation and growth. Notice how the debt addiction had started to creep up during the 1980's and 90's but then achieved full escape velocity after the GFC. The Fed will try a little tightening and be slow enough on the progression such that the economy's slowing will materialize more vividly. Then, depending on the severity of the pullback in asset markets, central bankers could be reaching for the liquidity fix once again. They may be wishing rates were higher already so they could be ready to do this anyway, given the risk profile of Eastern Europe at the moment. Or two, the Fed will come hard at inflation that hasn't been this high since, oh, the Fed Funds rate was over 10% (it rests at 0.08% today). They will actually raise rates in what we would think of as a legit cycle, where there are incremental raises for some period of time, the rate stalls out at some level and then the cutting part of the cycle begins.We put the fed funds effective rate and discount rate charts below so readers can see that cycles have been normal part of market environments for decades AND to see how depressed short rates are.
The gnashing of teeth around rate hike cycles by bears has steadily grown louder, roughly keeping pace with the perma-bulls picking and choosing their statistics to show higher rates are NOT bad for equity markets. VIEW is not in the position of having to be permanently positive, we care about allocating capital in the best way possible, for the highest risk adjusted return. As part of that, we think it is helpful to slow markets down and not spend inordinate time trying to interpret daily market moves. The amount of noise in short-term prices, with a larger dose of randomness than we feel the need to entertain, can be overwhelming in quantity and underwhelming in directional assistance. Levels do matter however, so we consider them and believe in constantly assessing markets and positioning capital aligned with most probable scenarios for the future. With that said, can we learn anything from past interest rate cycles? That is, after all, an underlying concern in markets today. With that in mind, we considered past rate hikes and here is what we found.
We consider there to have been eight major rate hike cycles since 1970, with an average duration of 43 months. Note, we are measuring the cycle from the first raise to the last cut, that is our definition, other may have theirs. The median magnitude from the initial raise to the peak was 225bps. What we consider the relevant results are as follows:
Average GDP growth rate at the first hike: 4.2%
Average CPI level at the first hike: 3.4%
Average GDP growth rate at the last cut: 2.4%
Average CPI level at the last cut: 2.3%
Average delta GDP first cut-trough in the cycle: -389bps
Average discount rate raise in the cycle from start: +322bps
While the averages above tell part of the story, we think looking at a comparable period of inflation is worthwhile to consider. The most recent US reading was 7.5% for CPI in January. In the rate hike cycles back to 1972, the mean CPI at the start of each cycle was 3.49%, with the mean peak rate 6.26%. The chart below has a scatter plot of the combination of CPI peaks with concurrent discount rates for our eight cycles. The take-away is pretty clear, given our current inflation levels and when looking back at what the Fed brought for a given CPI each time, the central bank is way behind.
It is interesting but not particularly constructive that the subject of inflation tends to devolve into debates among economists about causes, implications and even, justification. Because there have consistently been political implications due to periods of higher inflation, in whatever country has experienced it, politicians tend to also wade in. Some try to ignore government's role in causing price increases and blame commercial entities for bad acting. Others use it as a rhetorical club against their opponents, especially if the other party happens to be in control when inflation bubbles up. Or they even try to blame geopolitics. For the purposes of positioning, motivations matter somewhat as they can help predict reactions by the central banks to given future events. However, what happens during a rate hike cycle is pretty straightforward from what we see. For those interested in trading markets and positioning capital as adeptly as possible, how do we do distill the rate cycle topic? Arguing definitions, theories and politics might best be laid aside to see what experience tells us.
In every rate cycle since 1972, the Fed hiking cycle has corresponded with a slowing of the economy. It does not always result in a recession but VIEW thinks this completely misses the point. We are, as always, focused on the cycle. Rate increases of the number and magnitude implied in markets today slow the economy. By how much and whether a recession materializes is less important.
In just one of eight hiking cycles was inflation higher at the end than the beginning. The slowing economy is associated with waning inflation. In just the 72-76 cycle did inflation end higher than it started AND there was a recession in the middle of that cycle. Recall that in 73-74 the Arab oil embargo was instituted which caused a rapid appreciation in crude prices, what we think of as the big dog of inflation inputs. This was preceded by the related event of the cessation of international convertibility of USD/gold by President Nixon in 1971. This caused rapid depreciation of the dollar and contributed to a corresponding appreciation in oil prices as Brent is priced in USD.
Given that interest rate cycles appear to be successful in slowing the economy, it is important for investors to realize that this has a direct implication to where we encounter downside volatility. When VIEW looks at quarterly equity prices back to 1970, we find that 74% of the time prices decline on a year/year basis, the economy has sequentially slowed its rate of growth. In this instance the popular press is unhelpful in that there is an obsession with predicting and describing a "recession". Mostly, we think, so blame can be pinned somewhere. Regardless, what VIEW finds that matters is not level but rate of change. So, what we find is as growth slows, that is where the y/y declines in the equity markets congregate at least 3/4 of the time. The batting average demands our attention.
We think our interpretation of implications from a rate cycle square with our assessment that the economy is already slowing, that inflation is about to, although oil's geopolitical bid complicates the timing and degree here, and the Fed is in a very sensitive spot. VIEW sees the inflation genie well out of the bottle, the Fed late and plainly at risk of raising rates into a slowdown, thereby exacerbating it. We encourage close attention to the 10-2 US government debt spread. It sits at 38bps today, down 22bps from the end of January.
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