Market performance during Fed tightening cycles

Putnam Capital Market Strategies team, 03/16/22


Introduction

In this analysis we assess asset class performance during prior cycles of Federal Reserve monetary tightening. Specifically, we measured performance across interest rates, equities, and fixed income the year after the start of rate hike cycles. Additionally, we looked at the impact on U.S. 10-year note yields as well as the slope of the U.S. Treasury curve.

Background

Over the past 30 years, there have been four distinct tightening cycles. We define a tightening cycle as a period when the Fed increased the federal funds rate multiple times.

Exhibit 1: Fed tightening cycles Source: Federal Reserve Board, Putnam

In the sample period, the median number of Fed rate hikes is eight and the median time frame is 18 months, from the first hike until the final hike. Fed policy actions likely caused, or contributed to, economic recessions following the cycles ending in 2000 and 2006.

Impact on rates

The rates market is directly impacted by tightening cycles. Exhibit 2 shows the one-year change in U.S 10-year Treasury yields as well as the slope of the yield curve as defined by the difference in U.S. 10-year Treasury yields and U.S. 2-year Treasury yields. We observe that the yield curve tends to flatten, as short-term rates increased more than long-term rates. On average, the 10-year – 2-year spread compressed by 88 bps, or 0.88%.

Exhibit 2: U.S. 10-year yields and yield curve slope during Fed tightening cycles Source: Federal Reserve Board, Putnam

During prior Fed tightening cycles, U.S. 10-year notes saw a median increase in yields of 20 basis points. We also note that the yield curve flattened by a median of 88 basis points. Exhibit 3 illustrates U.S 10-year yields as well as the slope of the yield curve following the first rate hike.

Exhibit 3: Changes in U.S. 10-year Treasury yields and yield curve slope Source: Bloomberg, Putnam


Market Performance

S&P 500 performance

Exhibit 4 illustrates S&P 500 performance in the year following the Fed’s first rate hike. Markets have tended to trade lower in the months following the start of a tightening cycle, but in each case have ended higher one year later. Source: Bloomberg, Putnam

We observe the median drawdown to be 9% in the first 49 days following the Fed’s first rate hike.

Equities by size and style

Exhibit 5: Equity size and style performance one year following the Fed’s first rate hike Source: Bloomberg, Putnam

Median returns one year following the Fed’s first rate hike are:

  • S&P 500 6.24%
  • Russell 1000 Value 3.91%
  • Russell 1000 Growth 3.58%
  • Russell 2000 11.30%

  • Rates and credit

    Exhibit 6: Fixed income performance one year following the Fed’s first rate hike Source: Bloomberg, Putnam

    Median returns one year following the Fed’s first rate hike are:

  • U.S. Aggregate Bond Index 3.43%
  • U.S. Investment Grade 3.93%
  • U.S. High Yield 4.83%

  • Exhibit 7: Asset class returns across equities and fixed income one year after the Fed’s first rate hike Source: Bloomberg, Putnam

    One year following the Fed’s first rate hike, returns across all risk asset classes analyzed are positive. Excluding the TMT bubble of 1999–2000, the strongest returns in the equity space were found in the Russell 1000 value index. Similarly, the strongest returns in fixed-income space were found in U.S. high yield bonds.

    Conclusion

    The Fed is about to embark on a new tightening cycle. This will likely be the beginning of the fifth tightening cycle in the last 30 years. In the prior four cycles, it is fair to say that the Fed contributed to the recessions following the TMT bubble (2000) and the housing bubble (2006). There were no recessions after the tightening cycles of 1994 and 2015.

    We found the median number of rate hikes was eight, spanning a median of 18 months. U.S. 10-year Treasury notes increased by a median of 20 basis points and the slope of the yield curve, as defined by the difference between U.S. 10-year note yields and 2-year note yields, flattened by a median of 88 basis points. Following the Fed’s first rate hike, the S&P 500 declined by a median of 9% over 49 trading days. One year after the Fed’s first rate hike, the S&P 500 was 6.24% higher at the median. Within the equity space, the Russell 2000 Index generated a median return of 11.30%, significantly outpacing the returns of large cap indices such as the S&P 500, and the Russell 1000 growth and value measures, excluding the TMT bubble. When we exclude the run up to the TMT bubble, the Russell 1000 Value Index had the highest median return at 11.82%.

    Within fixed income, the U.S. high yield bond category generated a median return of 4.83%, outpacing both the U.S. Aggregate Index and U.S. Investment Grade Index. High yield bonds also outperformed in the sample ex-TMT.

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