Now that Janet Yellen and the Federal Reserve have all but made it official that a rate hike is inevitable, the question becomes how soon and how much? While consensus may be growing that the first of the coming rate increases will commence in June, I think the Fed will likely be more cautious and begin its “liftoff” during the September 16-17 meeting.
The good news is the period before the Federal Reserve raises rates is historically a great time to invest. Over the past six tightening periods since 1980, the S&P 500 has returned 23.5 percent on average in the nine months prior to the first rate increase. Assuming the next tightening cycle begins in September, the nine-month period this time around began in mid-December. Since that time, a number of indicators, including my favorite, the New York Stock Exchange Cumulative Advance/Decline Line, show that the stock market is improving and can sustain its upward momentum.
Looking beyond the myopic recent churn and burn, the important macro indicators remain positive, and nothing has occurred to fundamentally alter our positive outlook.
The period prior to a rate hike has also been a favorable environment for corporate credit. High-yield bonds and bank loans have outperformed investment-grade bonds on average by 4.0 percent and 1.6 percent, respectively, in the nine months leading up to the start of the last three tightening cycles. Even after the Fed begins to raise rates, tightening of monetary policy does not necessarily lead to an immediate widening of credit spreads. During four of the last five tightening cycles (1983, 1986, 1994 and 2004), default rates continued to fall for nearly the entire tightening period and ultimately ended lower than they were when the Fed started to tighten. In the past four instances where the Fed began raising rates following an extended period of monetary accommodation, high-yield spreads tightened on three occasions. On average, high-yield spreads tightened for nine months after the first Fed rate hike in a cycle.
All of this, combined with positive historical performance prior to past rate hikes, leads me to believe that a positive environment for U.S. equities and credit will continue between now and the first Fed rate hike.
But the question no one seems to be asking is once the Fed commences down the road of raising rates, how far will they ultimately go? Based on research we’ve conducted on the impact of higher rates on the U.S. debt burden, it appears the terminal value for the fed funds rate—the point at which the Fed stops tightening in a cycle—is around 2.5 to 3 percent, a lot lower than many people expect.
After the September liftoff, the Fed is likely to raise rates by 25 basis points every other meeting. Practically, this means the overnight rate should be in the 50- to 75-basis-point range by the start of 2016.
Longer term, the Fed will likely continue to tighten at a steady pace until it nears the terminal rate in the cycle, which I believe will occur toward the end of 2017 or early 2018 in the range of 2.5 to 3 percent. Supporting such a ceiling on the fed funds rate is research that shows a close historical relationship between the debt-to-GDP ratio in the economy and the terminal fed funds rate.
At 233 percent, the amount of debt as a share of GDP, excluding the financial sector, is among the highest since data became available in 1947. Given this level of debt in the economy today, and assuming the same pace of leverage expansion for the upcoming rate hike cycle as that during the 2004-2006 cycle, a terminal rate around 2.5 percent is where the economy is likely to begin to slow to an extent that forces an end to the tightening cycle. Knowing that policymakers typically overshoot, 3 percent would be in the cards as a possible terminal fed funds rate, which is within the standard error of estimate for the model. A recession typically occurs about a year after we reach the terminal rate, so if this tightening cycle plays out as I suspect, the U.S. economy won’t face its next recession until 2018 or 2019.
Why is the end of a Fed tightening cycle a concern today? Well, the yield curve generally flattens substantially by the end of a tightening cycle. In other words, 10-year Treasuries typically trade very close to the overnight rate (maybe 25 basis points higher). Therefore, understanding the economic constraints and terminal rate value of the upcoming “normalization” process can provide long-term investors with insights into the potential ceiling on 10-year Treasury yields, as well. In this case, if our view of the terminal fed funds rate is correct at 2.5 to 3 percent, then the end of the cycle in 2017 or early 2018 could see a ceiling for the 10-year note around 2.75 to 3.25 percent—a level much lower than many investors may be anticipating.
In the near term, we are potentially headed toward a period marred by winter distortions with regard to economic data here in the United States. If we do begin to witness a softening in data over the coming weeks, debate around the fundamentals of the U.S. economy will likely start afresh. Investors may even begin to question the Fed’s appetite for raising rates. However, I believe the underlying economy remains exceptionally strong and investors should not be panicked by seasonal setbacks. Indeed, considering the strength of the U.S. economy and the wave of liquidity emanating from various central banks around the world, the general investment environment should remain attractive.
The debt-to-GDP ratio is the ratio between a country’s government debt and its gross domestic product (GDP).
The New York Stock Exchange Advance/Decline Line (NYSE breadth) is calculated by taking the difference between the number of advancing and declining stocks in the equity index.
This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. This article contains opinions of the author but not necessarily those of Guggenheim Partners or its subsidiaries. The author’s opinions are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC. ©2015, Guggenheim Partners. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.
