Caution: More Volatility Ahead

The Federal Reserve may be finished raising interest rates, with recent U.S. inflation data roughly in line with Wall Street estimates. Investors will get confirmation of such a “pause” after the next Federal Open Market Committee (FOMC) meeting on June 13 and 14.

In the meantime, an equally important question looms: Would a pause—and potential rate cuts thereafter—lead to a new bull market or another drop for stocks?  

Bullish investors seem to view the potential pause as a stock-buying opportunity, based on the belief that the Fed will soon begin cutting rates, which would support higher equity valuations. However, recent signs of persistent inflation suggest the Fed may instead keep rates elevated for longer. What’s more, a look at past rate-hiking cycles suggests that more economic and market pain may be in store. 

A Quick History Lesson

There have been nine cycles in the last 50 years in which the Fed has raised rates. In seven of those, equities fell after the first rate cut, extending the bear market, and hitting a new low point in the cycle. The declines averaged about 23% from the final rate hike.

The only times stocks didn’t fall after the first rate cut were in 1989 and 1995. What was unique about those two episodes, and how do they compare with today? In short, economic and financial conditions back then were more constructive than they are now:

• First, Fed tightening had largely done its job of slowing the economy and cooling inflation. Unemployment was above 4%, showing some slack in the labor market (i.e., employers’ demand for workers was less than the available supply). Inflation was down to a manageable 3% or lower, while leading economic indicators were trending positive. In contrast, today we have yet to see the full impact from Fed policy-tightening. Unemployment is at a decades-low of 3.4%, leaving labor markets historically tight. And headline inflation remains relatively high at 4.9%, while leading economic indicators are down year-over-year.

• In both 1989 and 1995, yield curves were normal, or positive-sloping, especially the bellwether 3-month/10-year curve. This means that 3-month Treasury yields were lower than 10-year Treasury yields, signaling that markets had a positive long-term outlook and expected the economy to pick up. Today, the curve sits at around its most deeply inverted levels on record, with the 3-month yield higher than the 10-year by about 180 basis points. Inverted yield curves imply that investors are expecting growth to slow, causing the Fed to reduce rates meaningfully in the future.

• In the previous two instances, financial conditions were easing after rate hikes, and bank lending conditions were more favorable. Today, overall financial conditions are apt to tighten amid regional bank stress, debt-ceiling uncertainty and the lagging impacts of Fed policy tightening. 
  

Based on these observations, we can say it’s certainly not 1989 or 1995. The bullish scenario of equity market gains based solely on the end of rate hikes does not seem plausible.

At this time, we anticipate an extended period of volatility. Investors should take caution and consider portfolio rebalancing and dollar-cost-averaging (i.e., investing similar sums at regular intervals to “average out” purchases of securities at different prices). Consider looking for income opportunities in both stocks and bonds. Your Morgan Stanley Financial Advisor may also be able to help you manage volatility with so-called relative-value and multi-strategy hedge funds. Lastly, portfolio diversification across asset classes and regions remains key.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from May 15, 2023, “Good Pause or Not?” Ask your Morgan Stanley Financial Advisor for a copy. Listen to the audiocast based on this report.