The Federal Reserve at its last meeting raised rates to the 5.25%-5.50% target range for a cumulative total tightening of 525 basis points for the current hiking cycle. This is the largest and fastest hiking cycle since Volcker's by a large margin and has pushed real rates, in particular short-end real rates, to levels not seen since the early 2000s.
Markets are currently pricing almost even odds of just one more hike, and then, after a brief pause, the current pricing implies that the Fed will start cutting at a moderate pace. I think it is fair to say that whether the Fed hikes once or even twice from here, we are very near the end of the tightening cycle.
Data Source: Bloomberg
What is not clear and what is keeping rates markets active is the path to the first cut. Inflation data has significantly moderated but it is still running well above the 2% target. In particular, the supercore measure that the Fed has focused on is well above 2%. Also, the labor market has continued to show incredible strength. As our macroeconomic team pointed out in "FOMC Outlook: From High to How Long", it is unprecedented for the Fed to cut with such a strong labor market, with the most likely outcome being a prolonged period of rates at current levels. Looking at the last four hiking cycles it took the Fed 5, 8, 15 and 7 months, respectively, to cut after the last hike (9 months on average), so even 12 months, which is well beyond current market's expectation, would be completely plausible.
Given these dynamics, what can we expect for markets in the coming months? Lessons from historical Fed cycles are very interesting and we can draw inferences from these periods. One pattern that we have highlighted in previous works is the uncertainty surrounding the end of cycle period. Notably, when reading statements from the meetings that ended each hiking cycle, it shows a Fed that was still in hiking mode at those meetings. It is almost as though the lags of policy caught the Fed by surprise, slowing the economy faster than expected and subsequently leading the Fed to de facto stop hiking at all once. Hence, each hiking cycle concluded without any formal announcement or even a hint of one.
To deepen the understanding of end-of-cycle dynamics, we looked at the behavior of the yield curve in all of these episodes. In the spirit of factor models, we characterize the yield curve by level, slope and curvature and look at the dynamics of these three variables for the year before and the year after the last hike. It is well known that these three factors capture 99% of the variation in yields, so by focusing on them we can capture all the relevant macro dynamics while getting rid of idiosyncratic moves. We construct factors not as PCAs but rather using market convention: level is then the average of all yields, slope is the 2s-10s spread and curve is 2y-5y-10y fly.
From a rates perspective, 1994/1995, when Greenspan's Fed hiked rates from 3% to 6%, was as interesting as it can get; in fact, this period was characterized as "The Great Bond Massacre". It is not really fair to attribute all of the turmoil to the Fed as rates globally went up significantly (JGBs in fact preceded the selloff in Treasuries). However, the Fed hike of February 1994 and subsequent aggressive hiking caught the market by surprise and created a bond carnage with long-term rates moving up 300bps in a very short period. The behavior of average yields for all other cycles was a lot more muted than in 1994, but they all show an identical pattern of yields moving up right up to the point of the last hike and declining by about the same amount in the year following. It is important to notice that we are looking at the average of longer dated rates. Of course, Fed Funds will, by definition, peak around the last hike and then decrease as the Fed is cutting but longer-dated bonds should, in theory, incorporate this information and peak well before the last hike. Hence, what this pattern shows is that the market typically prices a risk of higher yields as long as the Fed is tightening and then gradually removes this "premia" after the Fed ends its hiking cycle.
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