Final interest rate increase – and then?

After ten, at times sharp, interest rate hikes within the past 15 months, US inflation seems to be tamed – albeit at a high level. In addition, the credit squeeze may make additional monetary tightening obsolete. We therefore anticipate a last interest rate hike of 5.5 percent in July. Interest rates will then only be eased again in spring 2024, as the US economy should slide into recession.

In order to obtain indications of how equities and bonds have reacted in the months following a final interest rate hike, we have prepared a historic analysis with data going back to 1973.

Sharp interest rate hikes are often followed by recessions and rate cuts

Our focus is on the US market, as it best represents global equities (67 percent share in the MSCI World). In median terms, it only took three months until the first rate cut and twelve months until recession, if one occurred (see table below).

Looking at the average share market trend after the respective final interest rate hike, a positive performance can be seen (see red line in Chart 1). However, it is not quite accurate, as the initial situation is decisive.

Performance of the S&P 500 indexed to 100 as at the latest interest rate hike

After the final interest rate hike in 1989, the S&P 500, for example, clearly rocketed. Nonetheless, with a P/E of 13, equity valuations were significantly lower than today at over 19. The strong stock market years of 2006 and 2018 can also not be compared, as inflation was not a major issue at the time. The situation in 1984 and 1995 was also different, because no recession followed then.

Years with a rate of inflation of more than five percent (1974, March and December 1980 and 1981) or with an already high valuation (2000) are more comparable to the current environment. Here, equities lost in the months following the last interest rate hike.

Bonds: Up in the sky

However, share price performance looks more homogeneous after the Fed peak in US government bonds. The restrictive monetary policy slowed down the economy and inflation, which boosted government bonds after each final interest rate hike. This occurred despite the existing inverse interest rate curve, because the yields on all maturities fell (bull flattening).

Performance of US government bonds indexed to 100 as at the last interest rate hike

Conclusion and implications for the portfolio

For equities, the picture looks negative given the high valuation and inflation. We are therefore maintaining our underweight in equities and positioning ourselves cautiously for the coming months. Markets are moving away from a “TINA” world (where there is "no alternative" to equities) to a world where there are alternatives again and fixed income securities are more attractive. Enhanced macroeconomic uncertainty, a probable economic downturn and higher returns may support a shift in allocations to fixed-income investments.

We do not expect a rapid decline from the interest rate peak due to the continued high US core inflation rate. We favour US government bonds as they are ideal for staying at the interest rate peak thanks to the currently attractive carry, and prices have always risen since the last interest rate hike in the past.