Pay close attention to the US Fed

DESPITE not raising the Federal Funds Rate (FFR) as was widely expected in the Sept 20 Federal Open Market Committee (FOMC) meeting, the US Federal Reserve continued to spin out a hawkish tone as it announced the commencement of the US$4.5 trillion balance sheet reduction. It will start tapering US$10 billion per month from October, and raising the amount gradually in the months to come if the economy grows in line with expectations.

A long-term study of the rate hike cycle since the 1970s shows a telling picture of its impact on the equity market. The Fed, with the smartest and brightest people on board, has the best knowledge about the health of the economy. Any action by the Fed on monetary policy had been indicative. The moment that it shifts towards a dovish defensive stance after a period of tightening is the time to be wary. We observed that a prolonged rate hike cycle tends to end with crisis and equity market downturn, and a change in monetary policy to the easing side usually signals it.

For example, the rate hike cycle that popped the dotcom bubble began in June 1999 after the FFR was raised from 4.75 per cent to 5 per cent. The aggressive tightening continued for one year before the Fed dialled back. Since June 2000, the Fed halted the rate hike cycle and kept the FFR flat at a high of 6.5 per cent. The FFR was left unchanged for the following six months, reflecting a sudden shift in sentiment from the Fed, and ultimately leading to the bursting of the dotcom bubble. The peak in the S&P 500 was formed when the FFR was left unchanged at 6.5 per cent. To be exact, the S&P 500 topped out in August 2000, two months after the FFR was left unchanged. All hell broke loose after the Fed reduced the FFR sharply from 6.5 per cent to 5.5 per cent in January 2001 as it exacerbated the equity market sell-off, ultimately dragging the S&P 500 down by 46 per cent.

A similar warning pattern happened during the housing boom period of the 2000s. The Fed embarked on a brand new rate hike cycle in June 2004, taking the FFR up from one per cent to 1.25 per cent. This time around, the rate hike cycle lasted longer as the Fed raised rates for 25 months before going into a defensive mode and keeping rates unchanged at a high of 5.25 per cent for the following 14 months. The market only got the clue that something was amiss after it reduced the FFR for two consecutive months in October 2007 from 5.25 per cent to 4.5 per cent. The FFR reduction kick-started the global financial crisis and aggravated the sell-off, resulting in a 52 per cent wipeout in the S&P 500.

Fast forward to today: This decade's rate hike cycle began in December 2015 with the Fed raising the FFR from 0.25 per cent to 0.5 per cent. In fact, the tightening cycle happened two years earlier in May 2013 after the Fed announced plans to taper back its US$85 billion per month quantitative easing (QE) programme. The current rate hike cycle might be more complicated than the previous rate hike cycles due to the adoption of numerous unconventional monetary policy programmes such as QE, and record low levels of interest rate for an extended period since 2009.

Four rate hikes have been achieved since December 2015 bringing the FFR to 1.25 per cent, and according to the most recent FED's dot plot projection, 11 out of 16 members see one more rate hike in December. The Fed funds futures is also signalling a high possibility of a rate hike in December at 70 per cent, suggesting that the Fed is still moving steadily within the current rate hike cycle.

Hence, we believe that the broad-based equity market should continue to remain unaffected and grind higher for now as the Fed continues to embark on the tightening trajectory.

In conclusion, watching the Fed's action tells a lot especially when there is a huge shift in sentiment from hawkish to dovish, from rate hikes to rate reductions. The consensus of the market should lean towards the "buy the dip" strategy until the dovish rhetoric surfaces where the FFR is allowed to stay flat for a prolonged period. Once the next FFR reduction takes place, there is a high chance that the market is facing something colossal. Will the current rate hike cycle lead to another crisis event? Only time will tell.

Pay close attention to what the Fed has to say in the following FOMC meetings.

Disclaimer: Chartpoint is provided by Phillip Securities Research for information only, and should not be construed as investment advice.