Investors have been disappointed this year as financial markets have reversed the course after each rally and resumed a painful march downward to new lows. 📉
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Overall, market sell‑offs have broadly coincided with the U.S. Federal reserve’s decisions to raise interest rates.
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And many believe that a sustainable rally will emerge 📈 once the Fed stops hiking and starts cutting rates, typically known as a Fed pivot.
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Currently, the question of a Fed pivot isn’t if; it’s when because the FOMC can’t continue to hike rates indefinitely.
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So, when exactly will the Fed pivot?
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Does the ‘fed pivot’ indicate a bullish signal for equity markets?Â
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If so, does history support it, or is it the other way around?
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Let’s find out.
What exactly is the Fed Pivot?
The Fed has two jobs:
Keep prices stable and,
Maximize employment.
Monetary policy adjustments, such as changing interest rates or buying bonds to manage financial markets, are how the Fed achieves both goals.
When the Fed slashes interest rates, it’s adopting an expansionary or “loose” monetary policy, meaning they are injecting money into the economy to stimulate more growth.
Meanwhile, when they raise interest rates to cool an overheated economy, they are implementing a contractionary or “tight” monetary policy.
When the central bank transitions from loosening to tightening or vice-versa, market professionals say the Fed is pivoting.
Federal Funds Rate
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Considering the Fed’s recent moves, the market priced in the 75 bps rate hike for November 2022, and when the Fed hiked the rate by a lower 50 bps for its December meeting, a majority of market participants considered it a Fed pivot.Â
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A true pivot, however, occurs when the Fed indicates an end of the rate-hiking cycle and starts cutting rates.Â
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For clarity, the Fed decreasing the rate of interest rate hike, is not considered a Fed Pivot.
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Additionally, the Fed pausing any interest rate hikes, is also not considered a Fed Pivot.
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A true Pivot, comes only when monetary conditions start to loosen, i.e. when interest rates start to decrease!
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It must be something more concrete, something that the Fed has consistently failed to give up until this point.
Historical Fed Pivots and the S&P 500 performance
Since 1970, there have been 08 instances when the Fed shifted from a hawkish (rate hikes) to a dovish (rate cuts) policy stance, and the stock market’s performance has been mixed following these policy shifts.
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Fed pivots in the early‑1980s and mid‑1990s were accompanied by market gains as the economy remained resilient enough to avoid a recession.
Meanwhile, monetary policy shifts did not help financial markets before the global financial crisis in the late 2000s or the early 1970s.
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In 2000, the Fed funds rate was 6.5% when the Fed switched to a dovish policy and began to cut rates all the way down to 1.5% by 2002. Although this resulted in some short-term rallies, the market did not bottom until the fall of 2002.
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During the Great Financial Crisis, the Fed funds rate was 5.25% when the Fed made its first rate cut in the 2007 fall. The Fed aggressively cut rates all the way down to zero by December 2008. The market ultimately bottomed in March 2009. In both instances, the stock market did not recover until the economy was poised for a rebound from the recession.Â
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This suggests that when Fed hikes caused a sharp slowdown in economic activity, resulting in a recession, stock markets performed poorly, even after a Fed pivot (1973, 2001 and 2007).Â
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However, when rate hikes did not cause a recession—a phenomenon known as a “soft landing”—stock markets rallied after the pivot (1984, 1995 and 2019).
Will the Fed Pivot in 2023?
Recently, a light at the end of the Federal Reserve’s (Fed) tightening tunnel has emerged.
Headline consumer inflation appears to have peaked at 9.1% in June 2022, and since then, monthly readings have steadily declined.
The most recent CPI report for November 2022 showed prices up 7.1% over the prior 12 months. That’s the lowest reading in a year and a step down from the October year-over-year CPI of 7.7%.
U.S. Consumer Price Index
While both headline and core inflation remain well above the Fed’s 2% inflation target, the data is, most importantly, moving in the right direction.Â
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Judging by the latest CPI report, a Fed pivot may occur if inflation starts cooling down more rapidly and the Fed achieves its 2% inflation rate as a target.Â
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And when could inflation begin to slow down more noticeably?
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Well, the answer may lie in the job market.Â
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The Fed is making sure the employment sector gets hurt, and there are fewer job openings. The rate hikes are steps in that direction.Â
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Currently, though, the unemployment rate is at a near-record low of 3.7%, and 1.7 jobs are still available per 1 unemployed worker. A meaningful reduction is not there in open jobs per unemployed worker that Powell had suggested would be the way to lower inflation.
U.S. Unemployment Rate
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Until the labor market begins to show weakness, the Federal Reserve won’t likely change the course.Â
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Financial markets agree on the near-term vision but see a rapid retreat from peak rates later next year.Â
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The ‘fed funds futures curve’ suggests that rates will peak sometime in April or May 2023 just under 5%, and—rather remarkably—enter a cutting cycle that will last all the way into 2025.”
Fed Funds Futures Curve
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While there will be continued debate on the degree and timing of the rate cuts, the one thing most investors seem to agree on is that the terminal rate will likely peak sometime next year.
Will a Fed pivot trigger the next stock market bull run?
Probably not — says history. At least not immediately.Â
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Historical data shows that stock prices performed poorly following the Fed pivot, especially when rate hikes caused a sharp slowdown in economic activity, resulting in a recession.
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And currently, with two consecutive quarters of declining GDP growth that meet the technical definition of a recession, many have started to worry about a recession.
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The 10-Year/2-Year treasury yield spread – the so-called most accurate recession predictor – recently witnessed its deepest inversion since 1971.
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Additionally, the continued weakness in the housing market and the steaky inflation have increased the likelihood that the U.S. economy may soon enter a recession, leading to poor performance in financial markets, even after the Fed pivots.
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While no one knows what the future holds, history suggests that if we do enter an official recession, stock prices may continue to fall even after the Fed pivots.
FINAL WORDS
Given the steady decline in monthly CPI readings – combined with growing expectations for a recession—markets are increasingly leaning towards the possibility that a sharp change in Fed policy could come in the months ahead.
- However, for the Fed to really pivot, and not just to slow rate hikes, they will need to see a 2% inflation rate as a target, pullbacks in house prices, fewer job openings, and likely an increase in unemployment.
- While history may or may not repeat, it may rhyme with other major rate cut cycles, implying that the S&P 500 had historically traded lower into a Fed pivot when the rate hikes did lead to a recession.Â
- This means that even if the Fed pivots in mid-2023, it may take investors a long time to recoup their 2022 losses. And they may even have to wait until 2024 to see any gains at all.
Please note that all the information contained in this newsletter is intended for illustration and educational purposes only. It does not constitute any financial advice/recommendation to buy/sell any investment products or services.
