A myriad of factors contributed to the highest U.S. inflation rate since the early 1980s. The COVID-19 pandemic squeezed the global supply chain, leading to shipping issues, difficulty with inventories, and labor shortages. In addition, food and energy prices soared after Russia invaded Ukraine in 2022. On the monetary policy side, the Fed kept interest rates near 0% while the U.S. government distributed trillions of dollars. The Fed also purchased massive amounts of U.S. debt securities, sending its balance sheet to an unprecedented level of more than 35% of U.S. GDP.

These events caused the Fed to aggressively increase interest rates over the past 14 months. From March 2022 through May 2023, the Fed implemented ten interest rate hikes, taking the Federal Funds rate from near zero to a range of 5.00%-5.25%, making it the second quickest monetary tightening cycle in recent history. (Exhibit 1). Rapidly increasing short-term interest rates created a higher cost of capital, aimed at slowing the U.S. economy and curbing inflation.

Since 1974, the Fed has not stopped increasing rates until the Federal Fund’s rate has been above the Consumer Price Index (CPI) annual inflation rate. That level was reached after the Fed’s most recent increase in May, when the upper bound of the new Federal Funds rate of 5.25% surpassed the CPI annual inflation rate of 4.90%. This same pattern occurred in each of the past eight tightening cycles before the Fed began cutting interest rates. (Exhibit 2).

In May, Chair Jerome Powell shifted his tone away from further tightening, indicating that he would be comfortable with a pause at the current target Federal Funds rate of 5.00-5.25%. While the Fed and market both agree that the Fed will pause in 2023, they disagree about the timing of the Fed’s first cut. The blue line in Exhibit 3 illustrates the implied Federal Funds rate from participants in the futures market, showing a likelihood that the Fed will start cutting rates in Fall 2023 and drop its target to 4.2% by January 2024. The orange dot represents the Fed’s expectation for the target Federal Funds rate by the end of 2023. As illustrated, the Fed clearly expects to pause, while the market expects the Fed to cut.

Regardless of when the Fed starts cutting rates, the more salient question is how the equity markets will react to a rate cut. One common perception among investors is that the stock market will perform well once the Fed starts cutting interest rates. History tells us this is not necessarily always the case. In fact, over the past nine rate cut cycles, more than half of the Fed’s first cuts were followed by drawdowns of more than -20% by the S&P 500 Index. The Technology bubble in the early 2000s and the Great Financial Crisis proved to be the worst scenarios, with the Fed cutting interest rates in the early stages of two secular bear markets. On the other hand, four of the nine occurrences were followed by minimal weakness and achieved strong 6-month returns, with an average return of 3.4% during the six-month period after the first cut. So while the market has experienced both bull markets and bear markets following the first rate cut, history does not indicate that the Fed’s accommodative policy will simply carry the market higher.

Valuations matter too. When the market had a drawdown of at least -20% after the Fed’s first cut, the average S&P 500 trailing PE ratio was 18. On the other hand, when the S&P 500 had a drawdown of less than -10%, the average PE ratio was 11.4. The current PE ratio of 20 could be another reason to be more cautious once the Fed makes its first cut.

Exhibit 4 illustrates the valuation and performance information over the last nine tightening cycles.

One reason the Fed’s first cut hasn’t always been the best predictor of equity returns is that higher interest rates have a lagged impact on the economy. During this recent inflationary cycle, the Fed has remained focused on tightening monetary policy, while understanding that this will slow economic growth.

According to the Fed’s dot plot, the FOMC anticipates unemployment will rise to 4.5% during this period of economic slowing. As shown in Exhibit 5, since 1969, the Fed has consistently underestimated the increase in unemployment during recessions by an average of 2.5% each cycle. As the famous quote often attributed to Mark Twain states, “History doesn’t repeat itself, but it often rhymes.”

Commentary offered for informational and educational purposes only. Opinions and forecasts regarding markets, securities, products, portfolios, or holdings are given as of the date provided and are subject to change at any time. No offer to sell, solicitation, or recommendation of any security or investment product is intended. Certain information and data has been supplied by unaffiliated third parties as indicated. Although Meeder believes the information is reliable, it cannot warrant the accuracy, timeliness or suitability of the information or materials offered by third parties.

Investment advisory services provided by Meeder Advisory Services, Inc., Meeder Asset Management, Inc., and/or Meeder Public Funds, Inc.

©2023 Meeder Investment Management, Inc.

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