Even if there’s another hike in June, the end is sufficiently at hand to ask what a pause means for the investment outlook. Probably not much, since it’s been widely anticipated for months and market pricing should already reflect it. Consequently, the pause is unlikely to refresh the upward market momentum. Nonetheless, there are multiple market implications to consider in light of the rate hiking cycle ending, now or later in the summer.
First, the market regime of the Fed intentionally tightening financial conditions (FC) to fight inflation is over, though it was effectively done early in the year. After conditions eased in January, Fed Chair Jay Powell didn’t push back against this at the 1 February FOMC press conference. The Fed also quickly provided essentially unlimited, though costly, liquidity to banks when the crisis began in March, a FC-friendly action. A Fed not trying to tighten FC removes a market headwind, but it’s not yet a tailwind.
Second, the end of FC tightening also means that the Fed is no longer an overt source of market volatility. It’s now closer to a neutral factor, on its way to being a volatility dampener once it starts cutting rates. It’s not coincidental that equity volatility has declined significantly since its March peak when the banking crisis began—the VIX is down from 26 to less than 16, while S&P 500 realized volatility has fallen from 19 to 12. Technical factors and relatively good macro data have helped. But the Fed’s aggressive intervention to prevent more banking stress implies that at this stage of the hiking and economic cycles it doesn’t want adverse market volatility.
Third, the Fed pausing doesn’t mean that the Fed put is back. Inflation is still too high, and it’s not certain that core inflation will fall back to 2%without the Fed keeping policy restrictive for another year. With private sector demand holding up and the labor market yet to show any significant cracks there’s little reason for the Fed to alter its restrictive stance any time soon. The Fed will likely be content to sit on the sidelines and hold tight for a while, assessing the incoming data before it makes its next move.
Fourth, markets have become highly anticipatory of Fed policy changes, pulling forward their impact relative to when they actually occur, which means there’s downside risk if the pause lasts a long time. Market pricing has always reflected the future, but in regard to Fed policy the timing is earlier and faster than ever. This stems from two changes over the past 15 years.
One, forward guidance is central to Fed policy since the GFC, which wasn’t the case before. Two, social media and mobile phones have accelerated how quickly and widely information and views spread across financial markets. Much was made of the banking crisis being the first in this era, but Fed hiking cycles are only in their second, the 2010s cycle being the first. Similar to how this environment can exacerbate bank run risk, it can also lead markets to price in anticipated rate cuts well before they happen. In past cycles, the S&P 500 typically didn’t bottom until after the Fed started cutting rates, not just stopping the hikes. Now it looks like equities have priced in not only the pause, but cuts later this year. The risk is that equities have gotten ahead in pricing cuts, but not the commensurate economic pain that would likely necessitate them.
Fifth, while the Fed put isn’t back yet, there may be an implicit investor put for equities not that far out of the money. Investors have been anticipating the Fed pivot since last summer, and have had ample time to de-risk their portfolios in preparation for a potential recession. Positioning data suggests that hedge funds are still relatively light on risk, many long-only asset allocators are underweight to neutral equities versus their benchmark, and retail investors have large cash holdings. In other words, there’s a lot of money waiting to be put back into equities. To point four above, there’s also a belief, or maybe fear, that once the Fed does start cutting, a new sustainable bull market will begin. That possibility could bias investors to be early rather than late in adding risk, with a decent pullback in equities viewed as a buying opportunity even before the first rate cut.
The bottom line: A pause and likely end of the Fed rate hiking cycle isn’t a boon to risk assets, since it’s already largely priced in across financial markets. Nor does the pause change what’s already set in motion for the economy due to existing tightening, with the risks skewed to the downside. At the same time, investors desire to be early on the Fed pivot to rate cuts will create resistance to equity markets declining more than 10%, unless growth and earnings fall much more than expected. That would take the S&P 500 a little below our 3800 year-end target. The net result is that equities still look unattractive relative to high-quality bonds at current levels. It will take more than a Fed pause to change that calculus.
Main contributor - Jason Draho
Content is a product of the Chief Investment Office (CIO).
Original report - The pause that doesn't refresh, 1 May 2023.