By Adam Carr
Not that it’s a fait-accompli or anything, but how would markets react if the Fed hikes this week? In contrast to market fears, history suggests that the price action may not involve what many have come to regard as the stock standard reaction. That is, bonds and equities selling off and the Aussie dollar weakening.
It’s fair to say that the lengthening odds suggest a good chunk of the market might be taken by surprise should the trigger be pulled. Not a big surprise maybe, but a surprise nevertheless. The Fed futures market is fairly firm that there will be no hike this week, looking more toward December and certainly by March next year. Similarly economists, having gone from an almost unanimous view that they would hike at this meeting, are now more evenly divided (46 per cent now say yes).
This in turn leaves the market exposed to what could be considerable volatility. Yet that fact need not lead to the kind of knee-jerk reaction that we’ve perhaps come to expect.
Admittedly there is strong theoretical support to back expectations for a sell off across stocks, bonds and the Aussie dollar. Especially when it’s what we’ve seen happen on numerous occasions as Fed rhetoric, or strong data, has lowered the bar to that elusive first hike.
Having said that, seasoned punters already know that there’s a big difference between how the market behaves in anticipation of an event, and that event eventually being realised. Think of that old stock market adage ‘buy the rumour and sell the fact’. It’s just one example of this seemingly inconsistent behaviour. History is littered with it. Well, littered might be an exaggeration when it comes to the Fed hiking rates. There have only been three such cycles since 1994.
Indeed many punters point to the Fed’s tightening cycle of 1994 to press the bearish case. True, in this instance stocks and bonds actually did sell off. The S&P500 had a 9 per cent correction, and US bond yields spiked by a good margin — some 175 basis points on the 10-year over the ensuing three months alone.
Yet importantly, by June the following year bond yields had given most of those gains back and equities were some 20 per cent higher. In fact the equity correction itself only lasted two months — and that was promptly followed by a 16 per cent rally over the next year.
In any case, that tightening cycle seems to be the worst of it. The market reaction since then has been much more benign. So in June 1999, even as the Fed hiked, equities continued to push higher — the S&P500 punched up some up 6 per cent the following month. Bond yields for their part didn’t do much over the following 12 months and were little changed on average. Maybe half a per cent higher, or so, than the average of the previous 12 months.
Then, during the last cycle in 2004, and after a brief 7 per cent dip, the equity rally was on. Mimicking the tightening cycle some 10 years before, this pull-back actually only lasted only two months give or take. Six months later stocks were up about 7 per cent from when the Fed hiked, while 12 months later, stocks were up nearly 20 per cent. Bonds actually fell following the Fed’s first hike and only one month after were about 80 basis points lower.
So if history is anything to go by, the worst case scenario is that we’re facing a very brief and modest equity pull-back which will be followed by a strong rally. Bond yields for their part have better odds of either doing nothing or even weakening!
That kind of reaction becomes much more likely when you think about some of the differences between this upcoming tightening cycle and previous ones. For a start, the equity market this time round is selling off into the decision. That wasn’t the case in the previous three cycles. Similarly, and unlike past cycles, neither cash nor government bonds are really a viable alternative investment.
As for the Aussie dollar, history gives less guidance. Back in ’94 the unit pushed a little higher after the Fed tightened — 2 cents maybe. It rallied more strongly in 2004, putting on 10 cents as the Fed hiked. Namely, this tends to occur because once the Fed hikes, the RBA usually follows. Having said that, during the cycle of 1999 the Aussie dollar fell dramatically — about 10 cents in six months. That was when Australia was being trashed for being ‘old economy’.
Regardless of what market pricing does though, the overwhelming reality is that if the Fed hikes — whether that’s this week, December, or as likely sometime time in 2016 — then this is very good news. This is a guessing game that’s been going on for five years and the Fed has taken every opportunity to delay. With that track record, when they finally do hike then markets will likely take that as a firm signal that the US economy is very strong indeed.