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.