TLT - Is The Fed Pause Bullish Or Bearish? Both

2023-05-10 06:00:00 ET

Summary

• The rate pause is near.
• Equities can outperform or underperform following rate pauses, depending on the condition of the economy.
• Probabilities favor bonds in the near term and equities in the long term, in our opinion.

With the Federal Reserve slowing down its interest rate hikes, speculation about when the Fed will pause its rate hiking cycle has been growing. We joined the chatter with our own forecast that the rate hike of 25 basis points in May would be the last . Time will tell if our assessment is correct or not.

The current rate hike cycle has been swift and strong. Compared to the last rate hiking cycle from 2016-2019, the magnitude is twice as high and the speed is twice as fast. This was necessitated by the surging price inflation experienced in the U.S. and globally.

Regardless of the exact date, the consensus view is that the pause is near. Futures market expectations, from the CME FedWatch Tool , is expecting a 78.77% probability that the Fed Funds rate will not change in June, i.e. a pause. By January 2024, the market expects a 99.88% probability of rate cuts. By all measures, a rate pause should be expected within months.

This raises the question, is the rate pause bullish or bearish for equities? The answer is: both.

While this may seem like a dodge of the question, it really depends on the investment time-frame and economic circumstances. Below is a chart of data compiled by Oxford Economics, Refinitiv Datastream, and Bloomberg. It demonstrates the performance of US equities following past rate pauses, categorized by time-frame and economic condition.

The first fact to notice is that on average during all time-frames US equities are higher following a rate pause. This adds one point to the bullish camp. This outperformance is due to the strong performance that occurs when no recession follows the pause. In the case of a "mild" recession, as defined as less than 3% rise in unemployment rate, equities have risen during each time-frame. Another point for the bullish camp.

It's only when a "severe" recession follows a rate pause that equities demonstrate negative returns. And in this case they are negative between 1-6 months after the rate pause. But by 12 months after the pause they are positive, on average. Point for the bearish camp.

Now notice how equities perform relative to bonds across the different scenarios. On average, equities do not outperform bonds for the first 6 months following a pause. During a mild recession, equities never outperform bonds. During a severe recession, equities dramatically underperform bonds.

Two severe recessions in the recent past were in 2001 and 2008. The following are charts of the performance of equities and bonds during those periods following the rate pause.

Starting with the rate pause in 2000, equities started to decline quickly before bottoming at -44.6% nearly 2 years later. In contrast, bond rates fell and bonds with duration experienced capital appreciation in addition to their coupons.

Starting with the rate pause in 2006, equities continued to rise and were positive for 2 years before bottoming at -43.6% almost 3 years later. Bond yields were stable for a year following the pause but started to decline after that and contributed to bond capital appreciation.

No two years or business cycles are exactly alike. We see similarities between today's economy and that of 2000-2001. This primarily includes excessive speculation in the most innovative and fad-inducing sectors. We compare the internet companies of the dotcom bubble with the crypto, AI, and technology companies of the 2021 bubble. The result is nosebleed valuations.

If you're not convinced of bubble-like behavior in 2021, merely compare the chart of the 2000-2001 NASDAQ with the 2020-2021 chart of ARKK , a flagship fund for innovation and momentum stocks.

Based on these similarities, we conclude that much of the speculative behavior has worked its way out of markets. One indication that investing sentiment hasn't completely changed is the fact that ARKK fund flows have not declined substantially. In 2022, while the fund's share price lost 66.97%, fund flows were positive at $1.2 billion. Year to date, fund flows are negative for the first year since 2015 at -$257 million.

Whether or not we expect a mild recession, severe recession, or none at all is a subject that we publish about frequently. You can read some of our latest thoughts here . In general, we expect a mild or severe recession in the US to begin in the next 12 months.

Based on historical data and the nature of interest rates and business cycles, our portfolios are overweight bonds and underweight equities. Within our equity allocation, we are underweight cyclical companies and overweight defensive.

Following the pause, we are neutral to bullish on equities in the short term. If our base case scenario of recession proves true, we are neutral to bearish on equities. Either way, we are bullish on bonds over the next 18 months and bullish on equities once the business cycle is near its trough. The future cannot be predicted with accuracy. Investing depends on probabilities.

Which camp do you belong; bull or bear? Leave a comment below.

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