Past rate-cut cycles offer clues to potential asset-class returns
The Fed cut signals that other nations may embark on a fresh set of rate cuts
THE US Federal Reserve is finally ready to embark on a new trajectory. It will cut the target Fed funds interest rates at its next Federal Open Market Committee on Sep 18, setting rates that will determine the risk-free rate in the financial markets.
This is likely to have multiple orders of impact through global financial markets, including currencies of major economies through a weakening US dollar and the value of real asset pricing, such as real estate.
It is easy to forget that as recently as the first quarter of 2022, the Fed had held its interest rates at zero. Since the first rate hike in March 2022, the Fed has raised rates 11 times, taking it from zero to 5.25 to 5.5 per cent.
Since then, for over a year, the Fed has been on hold, keeping interest rates at their highest level in 23 years. This has been a burden to some, but is also a boon for bank deposits and money market funds, which reflect a record level of liquidity sitting on the sidelines.
Money market funds, a haven for liquid assets, have a record US$6 trillion in assets. As rates fall, more such funds are likely to seek a new home.
At this juncture, it is worthwhile to look at past Fed rate-cut cycles and the impact they have had on key markets and asset classes. We look at all Fed rate-cut and hike cycles since 1990, when the Fed started setting a target interest rate.
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It was not until August 1991 that the Fed rates first fell below the current threshold of 5.5 per cent. Since then, we have been above 5.5 per cent for a total of 21 months over a 33-year period (or 383 months). In the current cycle, we have been at the 5.25-to-5.5 per cent threshold for 13 months. This shows how rare this sustained period of high interest rates has been in the past several decades.
Since 1990, there have been a total of six rate-cut and rate-hike cycles. Here is what an average hike cycle looked like: An average cycle concluded in 15 months, during which the Fed announced nine actions – either cuts or hikes of 34 basis points (bps), or 0.34 per cent.
The most recent rate-hike cycle was of normal length, lasting 16 months, but was one of the most aggressive by magnitude – with an average 0.48 per cent across 11 hikes. This is the second-largest number of hikes after the 2004-to-2006 period, but that hike cycle under former Fed chair Alan Greenspan was the slowest and most gradual hike of 0.25 per cent each time, taking rates from 1 to 5.25 per cent.
The rate-cut cycles typically lasted a shorter 14 months, but with a greater average cut of 39 bps. This may be due to the fact that rate cuts normally have been precipitated by some form of crisis, such as the bursting of the dotcom bubble, the global financial crisis and the shock of Covid-19.
It is interesting to see how some of the major asset classes perform in periods of rate cuts. Typically, fixed income assets always do well; it is the only asset class that has consistently generated positive returns. Bond prices rise as rates fall, generating capital gains. In particular, high-yield and emerging-market bonds with higher spreads have generated higher returns.
Other assets that benefit from falling interest rates tend to outperform. These include emerging market equities and small-cap equities, as the risk premium is reduced and valuation expansion occurs.
Of course, not all rate-cut cycles are the same, and it is important to understand the economic background which drives Fed rate policies.
Analysts have called for rate cuts since last year and have consistently got it wrong because of the resilience of the US economy. We have seen a strong and sustained growth momentum in the US economy, with an almost-Goldilocks scenario of strong employment as inflation eased from a stubbornly high level.
The most recent inflation data supports the Fed embarking on an extended rate-cut cycle, but the future path will also be data-dependent.
It is also important to remember that the Fed, unlike most other central banks, has a dual mandate of keeping unemployment and inflation at bay. Slowing inflation has set the stage for rate cuts, as well as recent concerns over rising unemployment.
The US economy is clearly cooling from a period of strong growth. However, it is not necessarily slowing at a rapid pace or likely to enter deep recession any time soon. If the economy continues to surprise on the upside, while the market is already pricing in some meaningful rate cuts, it is highly probable that the Fed has time on its side and may not cut rates rapidly or to an aggressively low level.
It is still unclear whether the Fed rates will ever go back to zero or close to zero unless there is a major crisis. Certainly, there are very few scenarios where aggressive quantitative easing would be required. This suggests that the recent past experiences, where a double whammy of aggressive Fed cuts and quantitative easing drove asset prices higher rapidly, may not be the likely scenario this time. In fact, the Fed is likely to be cutting rates into a quantitative tightening, which is still ongoing.
What the Fed cut signals is that other nations may embark on a fresh set of rate cuts. These include the European Central Bank, with slowing inflation and growth concerns, and major emerging market economies such as China.
With the US dollar already weakening, this is a boon to economies with heavy US dollar debt, as the cost of servicing falls and as the currency moves in their favour. It is also positive for countries with capital controls such as China that do not want a large interest rate differential with the US for fear of capital flight. This will allow such countries to embark on their own stimulatory rate-cut cycles.
Emerging markets (EM) are likely a major beneficiary. As the rate differential narrows, the FX will move. Many institutional investors play the EM currency through equities without hedging, as the rebounding growth/earnings coupled with the stronger EM currencies gives outsized US dollar returns.
There will be greater uncertainty and volatility in markets. It is important to note that despite the most aggressive interest rate hikes in history and a sustained higher interest rate environment, stock markets are at historical highs. High valuations raise concerns over markets’ ability to move higher.
Equity markets could still be a beneficiary of falling interest rates (assuming no crisis or deep recession), but there also will be strong demand for fixed income, which has had several years of underwhelming returns. With a starting yield above 5 per cent and falling interest rates driving capital returns, fixed income has finally proved its ability to serve as a diversifier, to dampen volatility while generating above-average returns.
Much of the short-term liquid assets sitting on the sidelines may go into higher-yielding fixed income assets. With active managers generating better excess returns in fixed income than equities, fixed income unit trusts and funds could be an attractive proposition for many investors, especially in Asia where investors favour income assets.
A globally diversified portfolio across asset classes, regions and sectors enables investors to enjoy long-term wealth accumulation with lower volatility and less reason to “time” the markets, whether the Fed is hiking rates or embarking on a new rate-cut cycle.
Samuel Rhee is chief investment officer and Hugh Chung is chief investment advisory officer at Endowus, a leading digital wealth platform with over S$8 billion in client assets across public, private markets and pension funds (CPF and SRS).
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