Interest rates are a key monetary policy tool used to impact economic conditions. Changes in interest rates impact asset classes differently We explore how the end of a Fed interest rate hiking cycle might affect US fixed income and equities.
Interest Rates & The Fed
The Federal Reserve ('Fed') sets the central fed funds interest rate for the US economy with the aim of maximizing economic growth while adhering to a dual mandate of low and stable inflation and maximum employment. Decisions on rate adjustments are made with reference to a variety of key economic indicators.1
Changes in interest rates affect asset classes differently. We explore how the end of a hiking cycle might affect fixed income and equities.
What happens when hikes end?
Over the last 50 years, eight notable interest rate hiking cycles took place. In each of these periods, the fed funds rate hit a peak before hikes were paused and subsequently cuts began.
The time between the last hike in a series and the first cut ranged from 15 months in 2006 to 1 month in 1984, with an average pause of 7 months between the last hike and the first cut.
| Duration | Peak Rate | Rate Change |
|---|---|---|
| 1974 – 1976 | 13.00% | -7.50% |
| 1981 – 1983 | 20.00% | -11.50% |
| 1984 – 1986 | 11.50% | -5.62% |
| 1989 – 1991 | 9.80% | -4.05% |
| 1995 – 1997 | 6.00% | -0.75% |
| 2000 – 2002 | 6.50% | -4.75% |
| 2006 – 2008 | 5.25% | -3.25% |
| 2018 – 2020 | 2.25% | -2.25% |
Past performance or correlations are no guarantee of future results. Real results may vary.
Fixed income after rate peaks
Fixed income has a direct relationship with interest rates. While yields move in tandem, prices have an inverse relationship - as interest rates are decreased, bond prices tend to rise, leading to greater total returns.
In addition to changes in interest rates, the total returns of fixed income investments are impacted by the maturity and coupon sizes of bonds. Credit quality equal, bonds with longer maturities and lower coupons will have greater sensitivity to changes in interest rates. This is quantified by a measure called ‘duration,’ with a longer duration signifying a greater price sensitivity to changes in interest rates.
We illustrate this below with indices of US Treasury bonds of various maturities. We see that the longer duration bonds showed overall greater price changes in the 2 years following Fed Fund rate peaks.
| Treasury Index: | 1 – 5 Year | 5 – 7 Year | 7 – 10 Year |
|---|---|---|---|
| Duration: | 2.78 | 5.64 | 7.54 |
| 1995 – 1997 | 14.9% | 17.0% | 18.6% |
| 2000 – 2002 | 18.1% | 22.4% | 21.9% |
| 2006 – 2008 | 14.1% | 18.4% | 19.2% |
| 2018 – 2020 | 8.8% | 15.9% | 19.3% |
Equities following rate peaks
Equities, as measured by the S&P 500 index, also generally performed well historically following a peak in interest rates, although with less uniformity than US Treasuries.
The periods that showed the strongest equity performances were those in which a US recession did not follow in the wake of the high-rate environment (1984, 1995, 2018).
The period following the 2000 interest rate peak ended in negative equity performance and coincided with the burst of the dotcom bubble that saw equity valuations come down from 27x in 2000 to 16x in 20023.
Looking within equity returns to sectors (see table below), there is no consistent historical beneficiary of interest rates peaking and beyond for the period for which we have data. Nor do we note a strong distinction between Cyclical and Defensive sectors. This is unsurprising given the unique issues present in every cycle.
We can note that with the exception of the 2000 rate peak, the Information Technology sector outperformed the S&P 500 index in the other periods. Consumer Staples and Health Care also outperformed during 3 of the 4 periods.
| empty table header | 1995 –1997 | 2000 – 2002 | 2006 – 2008 | 2018 – 2020 |
|---|---|---|---|---|
| S&P 500 Index | 62% | -25% | 1% | 50% |
| Defensive | ||||
| Consumer Staples | 85% | 32% | 16% | 41% |
| Energy | 57% | -3% | 60% | -26% |
| Health Care | 99% | -3% | 5% | 37% |
| Utilities | 31% | -16% | 34% | 27% |
| Cyclical | ||||
| Communication Staples | 45% | -52% | 11% | 64% |
| Construction Discretionary | 37% | -11% | -13% | 71% |
| Financials | 109% | 9% | -34% | 30% |
| Industrials | 67% | -11% | 2% | 44% |
| Info Technology | 98% | -63% | 16% | 116% |
| Materials | 43% | 18% | 38% | 50% |
| Real Estate | -1% | 26% | ||
3 Source: Bloomberg S&P 500 Index Price/Earnings Ratio as of January 31st, 2000 and September 30th, 2002
Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance or correlations are no guarantee of future results. Real results may vary.
Key take aways
Following the Covid-19 pandemic, US inflation rose rapidly, reaching close to 9%4 in June 2022, significantly higher than the Fed’s target rate of 2%. The Fed then began a round of interest rate hikes to combat this elevated inflation, and interest rates peaked at 5.5% in July 2023.
An end to rate hikes impacts both fixed income and equities. Historically, following a peak in interest rates:
- US Treasuries showed consistently positive returns
- Longer dated, more interest rate sensitive bonds experienced a greater positive impact on total returns
- Longer dated bonds locked in higher yields for longer
- Where a peak in interest rates was followed by an economic recovery, equities, as measured by the S&P 500 index performed strongly, with all or almost all equity sectors performing well
- Where equities started the period with very elevated valuations, equity performance over the following 24 months was mixed
4 Source: Bloomberg US CPI Urban Consumers YoY (Not Seasonally Adjusted) as of June 30th, 2022.
Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance or correlations are no guarantee of future results. Real results may vary. Opinions expressed herein may differ from the opinions express by other businesses or affiliates of Citigroup, Inc., and are not intended to be a forecast of future events, a guarantee of future results or investment advice, and are subject to change based on market and other conditions.
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