Sector performance after restrictive monetary policy
The variation in sector performance following peak interest rates offers valuable insights for investment strategies in the current market environment
Key points:
The federal funds rate's restrictiveness is relative to the natural interest rate, illustrating its nuanced role in economic policy.
Post-peak monetary policy restriction, financial services tend to underperform both one and two years later. Conversely, materials and energy sectors show the best performance one year following the peak.
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There’s a lot to unpack in this article. I’ve already written about peak interest rates and how long it takes for them to come down, as well as overall market performance after peak rates occur. Today, I’m shifting my focus to the performance of different sectors after peak rates. I’m also going to enhance what I consider a “peak rate” to be.
Peak rates
I've been thinking a lot about the federal funds rate and its limitations in indicating the exact point when the Federal Reserve most restrictively impacts the economy. To fully understand the Fed Funds rate, I think it needs to be viewed in relation to r-star, a critical economic concept. R-star is a proxy for the natural rate of inflation. It offers vital context, transforming our understanding of the Fed Funds rate. The introduction of this concept into market analyses came about in the following manner.
The concept of the natural rate of interest dates back more than 100 years. In an 1898 book titled Interest and Prices: A Study of the Causes Regulating the Value of Money, Swedish economist Knut Wicksell argued that one could not judge inflation by looking at interest rates alone. High market rates did not necessarily mean that inflation was speeding up, as was commonly believed at the time, nor did low rates mean that the economy was experiencing deflation. Rather, inflation depended on where interest rates stood relative to the natural rate.
The Federal Reserve sets the "market rate" of interest, forming the baseline interest rate in the economy. Increases in the fed funds rate consequently raise interest rates across mortgages, credit cards, and bank deposits. The Fed manipulates this rate to either cool down or stimulate the economy, given that an overheated economy can be more detrimental than the adverse effects of high interest rates. High rates impact businesses by increasing borrowing costs, leading to less hiring and expansion. They also affect affordability, particularly in housing, as increased interest expenses raise overall purchase costs. Understanding the "natural rate" is key to evaluating the Federal Reserve's impact on the economy. A federal funds rate above this natural rate indicates a restrictive policy, while a rate below signals an accommodative policy.
It's interesting to observe that the natural rate of inflation suggests two distinct phases, with a notable change occurring post-2008 Global Financial Crisis (GFC). Recent assessments show r* values remain consistent with those post-2008 levels. This raises questions about the likelihood of returning to a low interest rate environment. If these r* estimates are reliable, it suggests the possibility of encountering low interest rates again. Additionally, the economic throttle's relationship with Core PCE, the Federal Reserve's preferred inflation metric, offers further insights into this scenario.
The concept of the economic throttle slightly improves upon using the effective federal funds rate by helping identify peaks of economic restriction. Think of it this way: if the Fed funds rate is akin to temperature, then the economic throttle resembles the "feels like" temperature.
Regarding sector performance, the natural question arises: how do different economy sectors perform after peak monetary restriction? To analyze this, I used SPDR S&P sector ETFs as performance proxies. We have three notable peaks for analysis: the first in Q4 2000, the second at the end of the GFC, and the third in Q4 2023.
The analysis suggests caution due to the small sample size, meaning conclusions shouldn't be too heavily relied upon. The Global Financial Crisis (GFC) posed unique challenges, especially for financial services, which may not be replicated in future scenarios. It's important to consider the business model of banks: they borrow money (like customer deposits) at short-term, low-interest rates, and lend long-term. As a result, banks are fundamentally sensitive to monetary restrictions, particularly when the federal funds rate (the shortest term interest rate) surpasses longer-term rates. This is exactly what happens during peak monetary restriction. This situation's impact on banks is often evaluated through yield curves and key rate durations, an area worth exploring for further understanding.