What The Fed
Key Takeaways
The actions of the Fed will definitely impact global financial conditions and a lot of people try to guess what the Fed is trying to do to get a better investment outcome:
Beginning of 2024: a large majority of investment outlooks suggested that the Fed was likely to cut interest rates many times. Many experts advocated moving to bonds because of this.
So far for this year, that has turned out to be a costly decision (almost 5 times less of returns). Going forward, we do not know if this may reverse.
Research into stock market returns shows that there is no pattern as to whether rate hikes or cuts are good for stocks.
While there can be very short-term volatility over the longer term, stocks continue to perform just fine.
The president has very little effect on the economy. If you want to put blame or credit, the main person who influences the business cycle is the head of the Federal Reserve Bank.
— Robert Fogel
When talking about interest rates and economic conditions, most people will quote what the US Federal Reserve is doing. Each individual country and economy has their own monetary chief and central bank (for Singapore it is the MAS), but the focus inevitably shifts to the Fed’s Jerome Powell and the board of governors.
However, each country’s central bank decisions are determined by the country’s economic and financial conditions. So in that case, should we all be paying attention to what the Fed does? To some extent, perhaps — because the actions of the Fed undoubtedly has some impact on global financial conditions. But the outcome and returns from each geography may not correlate to what the Fed does.
For instance, this year Europe is facing a very different environment than the U.S. Both the Euro area and the U.K. flirted with recession in late 2023 before stabilising. As a result, the European Central Bank (ECB) has made the first of what is expected to be 3 rate cuts this year. China on the other hand, wants to cut rates but faces depreciation pressure on the renminbi. As such, the government is providing stimulus to the economy by selling bonds to deploy the funds, likely in the beleaguered property sector amongst others. The chart below shows what the various central banks are doing around the world.
The Where
So, when the news reports about rate cuts — it may not happen across the board. Other countries need to balance their own needs and the implications to their economy. Differences in interest rates between the various countries leads to changes in US dollar flows — which affects foreign investment, domestic inflation and other drivers of GDP like imports and exports.
The Why
The main reason why people are always trying to guess what the Fed is trying to do is because they think that by making a right prediction, they can get a better investment outcome. At the beginning of 2024, a large majority of investment outlooks suggested that the Fed was likely to cut interest rates many times.
The How
A result of that prediction was the call to overweight bonds as the beneficiary of those rate cuts. The charts below show the predictions priced into interest rate options. In Jan, investors assumed 7 rate cuts throughout the year with an approximate reduction of -1.4%.
A few months later, strong economic data and a seemingly lack of a reduction in inflation in the US led the Fed to announce that it would likely not cut until much later. This resulted in a quick change in expectations leading to only the possibility of 2 rate cuts and a -0.5% reduction this year.
The Consequences
The impact to investments from this quick change and failure of predictions can be quite large. The chart below shows this large difference in lost returns had you acted on predictions. That’s more than a 500% difference (5.2% vs. 26.6%). Prior to the start of the year, and with the seemingly large number of rate cuts on the horizon, both bonds and equities did well.
As the data being reported made it more and more unlikely that the rate cuts would materialise, bonds started to take a tumble and are still negative for the year.
Source: GYC, Yahoo Finance. Global stocks represented by MSCI ACWI, global bonds represented by the BBG U.S. Aggregate Index.
Should we really be concerned about how interest rates move then? Maybe not. The diagram below shows the return of stocks from 1954 to 2018 is charted vs changes in the Fed Funds Rate (base interest rate), 1 Year Treasuries, 5 Year Treasuries and 10 Year Treasuries. In essence, you can see that there is no pattern as to what interest rate environment will result in best or worst returns of stocks, whether or not there are movements in short or long rates.
So if you are concerned about the impact to your investments, whilst there can be very short-term volatility over the longer term, stocks continue to perform just fine.
The Future
For the rest of the year, what should investors be considering then? The fact that we are unlikely to see a global recession this year (recession probabilities are at very low levels) means that we are not going to see the type of aggressive rate cuts like in the past. As such, we will see interest rates settle at a more “normal” type of higher level than what we have seen over the last decade.
In addition, as markets are doing well, it is wise to always do a portfolio check-up and if you are not; to think about proper global diversification and maintain a well-diversified approach to investing to prepare your investments for the next period of volatility.
If you want to find out which strategies or allocations do best when there is volatility around interest rates, come and chat with us.
