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With the first Federal Reserve (Fed) rate hike expected in March, I looked at US equity-market performance in the wake of previous policy lows (i.e., the lowest point for interest rates prior to the start of a multi-step Fed-hiking cycle). As FIGURE 1 shows, the broad market typically weakens while defensive names dominate in the three months following the first interest-rate tightening.1 Looking 12 months further out, total returns have tended to improve.

 

Observations on Specific Sector Results

I think a few details in FIGURE 1 are notable:

  • Within cyclical sectors, energy, financials, and materials held their own in the immediate aftermath of the first tightening.
  • Real estate and utilities stood out for their extremely strong performance in the last two expansions, as both were characterized by falling rates.
  • Healthcare did well in two of the three expansions following the first tightening. The sector also screens well for being low-duration2 and low-beta.3
I’d also note that defensive sectors have tended to do better in the 12 months after a Fed move than in the 12 months leading up to the move.
 
With all that said, this expansion is different for a lot of reasons, including the Fed’s use of both its balance sheet and interest rates as policy tools, which makes extrapolation challenging.
 

FIGURE 1

US Equity Performance After the First Fed Tightening
Percent change after low in Fed policy

Past performance does not guarantee future results. Indices are unmanaged and not available for direct investment. The S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks. The table shows returns of S&P 500 Index sectors after the first rate tightening of the last three expansions in 1994, 2004, and 2013 (taper4). Real-estate sector data not available for 1994 period. For illustrative purposes only. Sources: Standard & Poor’s, Federal Reserve, Wellington Management.

 

Yields typically rise ahead of the first rate hike, but then they often move down after tightening begins.

A Few Thoughts on Bond Yields

There’s been a lot of interest in bond-yield behavior as well, which is highlighted in FIGURE 2. Yields typically rise ahead of the first rate hike, but then they often move down after tightening begins. This is consistent with somewhat weaker equity returns in the three months after the first Fed move. The exception was 1994, when the rate cycle was continuously revised upwards for a time.

 

FIGURE 2

Bond Yields Have Tended to Rise Ahead of Fed Tightening

Past performance does not guarantee future results. Sources: Federal Reserve, Wellington Management. 

 

Looking at market pricing of Fed rate hikes and comparing it to prior rate tightening over an expansion, there is room for the terminal rate—how high rates can go over the course of an expansion, as opposed to how much they might rise in the near future—in the US to move higher in the right global environment. Recently, in fact, market pricing for the terminal rate, which had been in the 1.75%–2.00% range, moved north of 2.00% for the first time, and it could go higher.

The one new variable is that with Fed balance-sheet runoff6 as an additional tool, there could be more of a tradeoff between rate hikes and balance-sheet normalization, which deserves monitoring. I continue to watch the shadow rate7 as a way to put the two together.

In conclusion, the move in real and nominal yields8 thus far in 2022 is consistent with what we’ve seen in prior rate-tightening cycles. Looking ahead, easing supply-chain pressures should give the Fed some room in the adjustment process. Over time, I would expect some firming in real rates, especially as the starting point is quite low. 

 

For more information on how rising interest rates can impact your investments, talk to your financial professional.

 

1 Tighening is the process of central banks raising interest rates and reducing the size of their balance sheets.

2 Duration is a measure of the sensitivity of an investment’s price to nominal interest-rate movement.

3 Beta is a measure of risk that indicates the price sensitivity of a security or a portfolio relative to a specified market index.

4 On May 22, 2013, Federal Reserve Chair Ben Bernanke announced that the Fed would start tapering asset purchases at some future date, which sent a negative shock to the market, causing bond investors to start selling their bonds. The Fed announced the actual taper in December 2013; starting the next month, purchases were cut by increments of $10 billion per month until they ended in October 2014.

5 A basis point is a unit equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income security.

6 Balance-sheet runoff is synonomous with a decrease in the amount of assets held. During and after the Global Financial Crisis (2008-2014) and the brief March 2020 COVID-19 economic downturn, the Fed supported the economy by adding  roughly $8.3 trillion in Treasuries and mortgage-backed securities to its balance sheet. In light of the recent economic recovery and the recent resurgence of inflation, the Fed has annnounced a strategy of gradually shrinking the amount of assets it holds.

7 When the federal funds rate hovers near zero, many economic models stop working. Researchers developed a “shadow rate” that can stand in for the federal funds rate, drop into negative territory, and make those models functional again. The shadow rate tracks the movements of various benchmark data.

8 Nominal rates are not adjusted for inflation, while real rates are adjusted.

Important Risks: Investing involves risk, including the possible loss of principal. Security prices fluctuate in value depending on general market and economic conditions and the prospects of individual companies. • Fixed-income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • US Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest. • Focusing on one or more sectors may subject investors to increased volatility and risk of loss if adverse developments occur.

The views expressed herein are those of Wellington Management, are for informational purposes only, and are subject to change based on prevailing market, economic, and other conditions. The views expressed may not reflect the opinions of Hartford Funds or any other sub-adviser to our funds. They should not be construed as research or investment advice nor should they be considered an offer or solicitation to buy or sell any security. This information is current at the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

WP669 228080

Insight from sub-adviser Wellington Management
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Macro Strategist

 

 

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