What a Fed pause means for investors

What happens if the Fed does pause has been treated as a foregone conclusion, the economic theory is quite clear: stock prices and interest rates are inversely related, meaning when rates go down, stocks should go up.

The logic is very simple. When interest rates come down, investors will be less satisfied with the lower yields on bonds and fixed income and will seek a higher return on equities. Companies will find it easier to borrow and therefore will invest more in income generating projects. The present value of cash flows generated by stocks is increased by a lower discount rate.

Indeed, if we take a simple average of performance in the year after a Federal Funds Rate peak, we find that US stocks tend to rise by 7% on an annualised basis. However, this single number does not tell the whole story. When we take averages, we ignore outliers and downplay risks which might in fact be significant. When we take a more granular look, we find that, out of the twelve significant peaks of the Federal Funds Rate that we analysed, US equities fell in four of them.

There are several reasons this can happen. Timing can play a role, if market expectations don’t match reality. Weak economic fundamentals or financial accidents can outweigh the positives of lower rates. Investors may also worry if inflation seems persistent, and that rate cuts are premature.

A good example is the early 2000s. In mid-1999, the Fed raised rates, fearing an asset price bubble and entrenched inflation expectations. After the collapse of the dot-com bubble, caused by overhyped valuations for internet companies, the swift 475 basis points worth of rate cuts which followed came too little too late to counteract the market selloff.

The case of the 2000s selloff reminds us that rates are not always everything. The overvaluation of tech companies was enough to override any optimism that may have come from rate cuts. Rate cuts were no longer interpreted in the classical way, but as a sign that the Fed saw weaknesses in the economy.

Certain comparisons may be drawn between 2000 and now: market performance both then and now was highly concentrated in one area (tech) and the risk of financial accidents affecting certain areas of the economy has been voiced (such as in shadow banking or commercial real estate). The persistence of inflation beyond the point at which markets are expecting rate cuts to occur is another significant risk – inflation in 2000 also varied around 3-4%.

These confounding factors are less clear if the inverse relationship between rates and stock prices hold, especially as AI technology paves an unprecedented path, and inflation volatility stands at its highest level in decades. What is clear is that an average performance of historical periods is not trustable in our current environment, and fixating on the path of the Fed alone may not be good enough by itself.

Tao Yu, Quantitative Analyst 

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