Strategy Question: How could the Fed pause, banking stress and the debt ceiling impact markets?
Starting with the Fed, are we at the end of the Fed’s historic hiking cycle and what does it mean for markets?
Over a year and 500bps since the start of the tightening cycle, the Fed raised its policy rate this week by 25bps to a target range of 5.00% - 5.25%, the highest since 2007. The FOMC also removed a key line from its official statement that said it “anticipates that some additional policy firming may be appropriate”, hinting that this latest hike may be the last of the cycle and future moves will be data-dependent. Markets seemed to have broadly expected the outcome, and they reacted with yields down and stocks selling off.
THE FED HAS HISTORICALLY CUT RATES 6-7 MONTHS AFTER PAUSING
Fed Funds Rate and 10-year Treasury yield, %
We think it is likely that we have seen the last rate hike this cycle, unless there’s an unexpected reacceleration in growth, or if inflation fails to slow from here. The recent stress in the banking sector means that lending standards have tightened more swiftly. Before this bout of banking stress the Fed appeared to be targeting a higher terminal rate, but financial instability and the resulting slowdown in credit growth has a similar effect of a couple of rate hikes. Looking forward, the ongoing credit tightening will be in focus. This is likely to slow growth, which supports our base case for a U.S. recession in the back half of this year, with rate cuts to follow. Small businesses are already reporting that credit is harder to find. The office real estate sector will likely continue to struggle. Jobs data is starting to show early cracks. Chair Powell acknowledged that tighter credit conditions will weigh on economic activity, hiring and inflation, but the extent of those effects remain uncertain. The Fed’s data-dependent approach means they may keep the door open to additional hikes if the economy remains resilient with strong wage growth and above-target inflation, which is one of the potential risks on the horizon. Chair Powell also stressed that policymakers are still committed to conquering inflation, and it looks like more weakness in the labor market is needed to get it back to the Fed’s 2% mandate.
With the Fed near (or at) the end of its hiking cycle, many market participants have asked what the end of a hiking cycle tends to mean for markets. Starting with fixed income – in the average recession back to the 1950s, the Fed has cut its policy rate by an average of ~300bps over the following year (excluding Volcker’s 1980 reign). Today, the market only has ~120bps of interest rate cuts priced in over the next 12 months, suggesting rates have room to fall more from here. That means two things: 1) reinvestment risk is real, and 2) longer duration can still offer compelling returns.
Reinvestment risk is the possibility that an investor will have to reinvest money at a rate lower than its current rate. Given that T-bills only have a maturity of a couple years, and we expect rates to fall further from here, that ~5% yield has a looming expiration date. What’s more, with inflation also around ~5%, the real yield on T-bills is flat at the moment.
Alternatively, longer duration core bonds are still offering historically compelling yields (~5% in investment grade bonds), and the opportunity for price gains and portfolio buffer over the next year.
Putting it together: Upon the Fed’s last hike over the past seven cycles, U.S investment grade bonds have outperformed T-bills by ~14% on average (~27% vs. ~13% in T-bills). With the hiking cycle nearing its end, reinvestment risk is now a bigger enemy of a long-term investor than interest rate risk. Over the past seven hiking cycles, extending duration has outperformed money markets by an average of 14% in the 24 months after the last rate hike.
AVERAGE TOTAL RETURN FROM FINAL FED HIKE OVER THE LAST SEVEN HIKING CYCLES (since 1981)
For equities, it depends on what happens next in the economy. On average equities have trended higher following the last Fed hike. But looking beneath the surface, what matters more is whether the hiking cycle causes a recession. In the cycles when a recession resulted from higher rates, equities were either down or nearly flat over a two year time horizon, however in cycles when the Fed hiked but did not tilt the economy into a recession, equities were up by a larger margin. Thus the hard vs. soft landing debate becomes much more relevant for equities. From our perspective, with recession risks remaining high, we recognize the risk/reward in fixed income as being more attractive than equities.
WHAT HAPPENS AFTER A FED PAUSE? IT DEPENDS IF A RECESSION FOLLOWS…
S&P 500 price change from final Fed hike over the last seven cycles
What’s next after the latest bank takeover?
Stress in the U.S. banking sector does not seem to be over, and J.P. Morgan’s takeover of the troubled regional bank First Republic is just the latest episode in this saga. Since Silicon Valley Bank’s failure, ~4% of U.S. small bank deposits have flocked to the safety of big banks and money market funds (MMF). In April, small bank deposit outflows stabilized, which is a clear positive. The Fed’s quantitative tightening (QT) continues to drain aggregate liquidity, while deposits increasingly leave the banking sector in favor of MMFs. In business cycles dating back to the late 1980s, MMF AUM has grown by an average of 20% in the 12 months after the last Fed rate hike. Assuming May 3rd was the last Fed rate hike for the cycle, history suggests MMF AUM will likely rise by $1tr in the coming year. Until the Fed cuts rates, banking stress is unlikely to be alleviated.
All banks will likely have to pay higher yields to prevent deposits from fleeing to MMF; however, with confidence impaired and deposits already depleted, small banks will likely see some of the highest deposit rates (reducing profitability and hampering lending activity). Additionally, U.S. regional banks have a higher concentration in commercial real estate, where loan impairment is most at risk. This means smaller banks are more vulnerable, and we believe the small bank lending channel could potentially impact GDP even if the office sector itself isn’t big enough to.
BANKS ARE FEELING THE STRAIN FROM DEPOSIT OUTFLOWS
U.S. commercial bank deposits, indexed January 2021 = 100
All banks share some headwinds, however, with interest rates high and growth slowing – namely, increasing loan loss provisions, competing with higher money market fund yields, and declining net interest margins. Importantly though, we’re staying defensive, not fearful, with an acute focus on well-capitalized institutions when making investment decisions.
MONEY MARKET FUND YIELDS CREATING TOUGH COMPETITION FOR SMALL BANK DEPOSITORS
How could the debt ceiling saga play out?
Another issue that the market is concerned with is the U.S. debt ceiling debate. Treasury Secretary Janet Yellen warned that the U.S. government may run out of cash by June 1st if Congress fails to raise or suspend the debt ceiling. The statement pulled the date of potential default, or the “X-date”, forward by over a month, as most estimates were pointing to a July/August deadline. While we believe an actual U.S. government default is unlikely, this sets the stage for markets to relive some of the drama of past debt ceiling fights under a divided government. Market reactions amid historical episodes varied, with most accompanied by a dip in the prices of bonds that were potentially subject to delayed payments around the “X-date”. Nonetheless, in the 2011 episode when Congress increased the ceiling just days before the X-date and the credit rating of U.S. debt was subsequently downgraded, markets saw a significant risk-off move with IG credit spreads widening to over 250bps and a rally in Treasuries.
For investors, we see a couple of ways to hedge against a disorderly episode. Shorting T-bills due to mature around the “X-date” would be a straightforward way to hedge. Alternatively, we can consider shorting the USD against alternative reserve assets including EUR, CHF, JPY and gold. The below chart shows USD underperformance against each of those assets in the lead-up to the 2011 episode. The rally in gold was also significant especially amidst the immediate debt-ceiling related volatility, making it another source of protection that investors can consider.
2011 DEBT CEILING DRAMA WEIGHED ON RISK ASSETS
Returns during 2011 debt ceiling episode (resolution = August 2, 2011)
While markets are being buffeted by various sources of volatility and uncertainty, we’re staying defensive and balanced in portfolios. Yields have fallen off their highs, which reminds us that bonds can provide protection during times of stress. We still see opportunity here as the growth outlook is likely to worsen and pressure yields downwards, which makes us focus on high-quality investment grade credit. Equity markets could remain volatile and range-bound, and we are looking for protection and quality. Volatility could stick around, and we like structured notes that can both protect gains and build in some downside protection. We also continue to see opportunities in certain sectors (industrials, healthcare and reasonably-priced tech) and markets (China).
All market and economic data as of May 04, 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
For illustrative purposes only. Estimates, forecasts and comparisons are as of the dates stated in the material.
There can be no assurance that any or all of these professionals will remain with the firm or that past performance or success of any such professional serves as an indicator of the portfolio’s success.
We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.
This document may also have been made available in a different language, at the recipient’s request, and for convenience only. Notwithstanding the provision of a convenience copy, the recipient re-confirms that he/she/they are fully conversant and has full comprehension of the English language. In the event of any inconsistency between such English language original and the translation, including without limitation in relation to the construction, meaning or interpretation thereof, the English language original shall prevail.
This information is provided for informational purposes only. We believe the information contained in this video to be reliable; however we do not represent or warrant its accuracy, reliability or completeness, or accept any liability for any loss or damage arising out of the use of any information in this video. The views expressed herein are those of the speakers and may differ from those of other J.P. Morgan employees, and are subject to change without notice. Nothing in this video is intended to constitute a representation that any product or strategy is suitable for you. Nothing in this document shall be regarded as an offer, solicitation, recommendation or advice (whether financial, accounting, legal, tax or other) given by J.P. Morgan and/or its officers or employees to you. You should consult your independent professional advisors concerning accounting, legal or tax matters. Contact your J.P. Morgan team for additional information and guidance concerning your personal investment goals.
Indices are not investment products and may not be considered for investment.
For illustrative purposes only. This does not reflect the performance of any specific investment scenario and does not take into account various other factors which may impact actual performance.
These are presented for illustrative purposes only. Your actual portfolio will be constructed based upon investments for which you are eligible and based upon your personal investment requirements and circumstances. Consult your J.P. Morgan representative regarding the minimum asset size necessary to fully implement these allocations.
Past performance is not a guarantee of future results. It is not possible to invest directly in an index.
Structured product involves derivatives. Do not invest in it unless you fully understand and are willing to assume the risks associated with it. The most common risks include, but are not limited to, risk of adverse or unanticipated market developments, issuer credit quality risk, risk of lack of uniform standard pricing, risk of adverse events involving any underlying reference obligations, risk of high volatility, risk of illiquidity/little to no secondary market, and conflicts of interest. Before investing in a structured product, investors should review the accompanying offering document, prospectus or prospectus supplement to understand the actual terms and key risks associated with the each individual structured product. Any payments on a structured product are subject to the credit risk of the issuer and/or guarantor. Investors may lose their entire investment, i.e., incur an unlimited loss. The risks listed above are not complete. For a more comprehensive list of the risks involved with this particular product, please speak to your J.P. Morgan representative. If you are in any doubt about the risks involved in the product, you may clarify with the intermediary or seek independent professional advice.
- Past performance is not indicative of future results. You may not invest directly in an index.
- The prices and rates of return are indicative as they may vary over time based on market conditions.
- Additional risk considerations exist for all strategies.
- The information provided herein is not intended as a recommendation of or an offer or solicitation to purchase or sell any investment product or service.
- Opinions expressed herein may differ from the opinions expressed by other areas of J.P. Morgan. This material should not be regarded as investment research or a J.P. Morgan investment research report.
The Bloomberg U.S. Aggregate Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate pass-throughs), ABS and CMBS (agency and non-agency).
Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.