How the Fed's Pivot Could Reshape Your Investment Appetite
The Federal Reserve is the U.S. central bank, meaning that it oversees the nation’s monetary policy. The Fed has a dual mandate: to maintain both price stability and full employment. If inflation rises and unemployment falls, the economy may overheat, so the Fed will enact a tight, or contractionary, monetary policy—such as raising interest rates—to try to slow economic growth and let the economy cool. Likewise, if inflation is low and unemployment is high, the Fed may enact a loose, or expansionary, monetary policy to stave off recession by lowering interest rates and pumping more money into the economy.
With inflation running at multi-decade highs, the U.S. Federal Reserve (Fed) proceeded with a contractionary monetary policy and began to raise official interest rates in March 2022. It has continued this tight monetary policy, hiking rates 525 basis points in less than two years. This extraordinary jump in rates is just starting to have its desired effect of lowering inflation. However, it has also caused several unintended consequences, including the recent regional banking crisis and a spike in Treasury yields.
Pricing pressures, as measured by the personal consumption expenditures price index, or PCE, reached a high of 6.8%1 on an annual basis in June 2022, driven largely by soaring energy prices, which soared 43.5%, and food prices, which jumped 11.2%.
After two years of battling inflation, central bankers are finally beginning to see the results of their rate hike campaigns, with the PCE price index2 dropping to 3.4%, year over year, in September. Will falling inflation be the impetus for a Fed pivot on monetary policy?
Probability of a Fed pivot
With inflation not yet at the Fed’s stated goal of 2%, market watchers were still predicting one more rate hike just last month. But recent events have shifted that view, with an overwhelming majority of analysts anticipating the Fed is at or near its terminal rate.
The CME FedWatch Tool analyzes Fed Funds futures prices to assess the likelihood of rate changes during Federal Open Market Committee (FOMC) meetings. On Sept. 23, there was a 27.5% probability that the Fed would raise rates one more time; one month later, that number had fallen to zero.
|Target Rate (BPS)||Probability (%)|
20 Oct 2023
16 Oct 2023
22 Sep 2023
*Data as of 23 Oct 2023 08:04:35 CT
1/1/2025 and forward are projected meeting dates
Additionally, the probabilities of a Fed rate cut have started to creep into earlier FOMC meetings. As shown below, the probability of rate ease has risen from last month.
CME Fed Watch Tool - Total Probabilities
|Meeting Date||Days to Meeting||Ease||No Change||Hike|
|Meeting Date||Days to Meeting||Ease||No Change||Hike|
|Meeting Date||Days to Meeting||Ease||No Change||Hike|
Fed Policy and Fedspeak
Minutes from the September Fed meeting3 indicated that most Committee members expected one more rate hike in 2023 and that rates would stay higher for longer. However, despite its goal to return inflation to 2%, the Fed held interest rates steady at the October Federal Open Market Committee meeting.
Fedspeak may be suggesting a Fed pivot. Citing the recent spike in long-term Treasury yields, several Fed officials have said that the bond market is doing the central bank’s job in tightening financial conditions, reducing the need for further rate increases.
The yield on the benchmark 10-year Treasury jumped dramatically since the beginning of the year. The bonds, the basis for interest rates including mortgages and corporate debt, briefly hovered over 5% in late October, a high not seen since the Great Financial Crisis.
U.S. 10-Year Treasury Yield
Recent Fedspeak included Fed Vice Chair Philip Jefferson4 indicating the central bank would "proceed carefully" in deciding on further increases. Dallas Fed President, Lorie Logan,5 noting the spike in yields, said, “Longer-term rates therefore influence economic activity more directly than does the fed funds rate,” and there may be “less need to raise the fed funds rate.” Philadelphia Fed President Patrick Harker6 voiced a similar sentiment, stating in an interview with the Wall Street Journal that he believed the rate hike cycle was over.
Fed Chair Powell7 also remarked that longer-term bond yields have been a factor driving a tightening in financial conditions and the threats of doing too much or too little in the central bank’s battle against inflation.
To understand what is driving Treasury yields higher, economists use a theory known as “term premium.” As defined by the New York Federal Reserve, “term premium“ is the compensation that investors require for bearing the risk that interest rates may change over the life of the bond. Since the term premium is not directly observable, it must be estimated, most often from financial and macroeconomic variables.”
In other words, markets determine rates on longer-term borrowing, while Fed officials control short-term interest rates. Economists have estimated that the recent spike in Treasury yields has reduced economic activity by 0.6% over the next year due to tightened financial conditions — equal to roughly three interest-rate increases of a quarter-point each8.
Current geopolitical events and potential Fed pivot
The conflict in the Middle East sparked by the attack on Israel by Hamas may accelerate a Fed pivot as a protracted war could throw central bankers a curveball. A worst-case scenario for the conflict would be the war extending past Gaza and involving the United States and Iran, which is both a supplier of arms and money to Hamas and one of the top ten oil producers in the world.9 Bloomberg economists predict oil to spike to $150 per barrel if there is direct conflict with Iran.
Undoubtedly, the conflict will add an unpredictable set of forces to the global economy that is already dealing with the war between Russia and Ukraine. Pricing pressures could begin to increase again, particularly oil prices, which could cause inflation to skyrocket again— and tip the global economy into a recession.
Past Fed Pivots
Outside of the rate cuts enacted in reaction to the pandemic, the last time the Fed pivoted to a rate cut was in 2019, cutting rates three times and nearly completely reversing the prior year’s hiking cycle. During this mid-cycle adjustment, the Fed cut rates by 25 basis points in August, September, and October, dropping the Federal Funds rate to 1.50% - 1.75%. For the year, almost every asset class did well. The S&P 500 (with dividends) jumped 31.21%, gold spiked 18.83%, and the total return on corporate bonds was 15.33%10.
What asset classes might do well in a Fed pivot?
Treasuries. A prolonged escalation in the Middle East could lead to a risk-off environment as investors seek the safety of government bonds, which have underperformed for the past two years. The long end of the U.S. Treasury market is seeing the highest levels of turbulence since the height of the pandemic-era panic of March 2020. And even prior to a Fed pivot, bond bears are going into hibernation. Bill Gross, co-founder of Pacific Investment Management, and investor Bill Ackman have stated that they have become less bearish11 on U.S. government bonds.
As the Fed nears its terminal interest rate, a decreasing yield scenario and a flight to safety may make bonds attractive again.
Gold. Gold has historically had an inverse relationship with interest rates. As the chart below shows, when real yields go down, gold goes up, and vice versa. In addition to the possibility of falling rates, the current geopolitical situation may also suggest the return to safe-haven assets, such as gold.
Gold vs. Inverted Real 10-Year Treasury Yields
Source: Longterm Trend.net
Preferred stocks. Could a Fed pivot lead to attractive returns and tax-advantaged income from preferred securities? As fixed-income products with equity-like traits, preferred stocks act as a hybrid, with many paying qualified dividend income that is taxed at a lower rate than interest. Along with bonds, preferred securities have recently underperformed. But with the potential for a Fed pivot, now may be the time to look at preferred stocks.
A recent report by Cohen & Steers12 shows preferred securities outperforming other types of fixed-income products after a period of rate hikes. And given the low correlation preferred shares have with common shares, they can provide a diversification tool as well.
Average 12-month return following last rate hike (%)
Source: Bloomberg, as of 11/30/2022
Small-cap stocks. Market returns over the past several months have been led by the mega-cap tech stocks, leaving small-cap stocks in the dust. With higher exposure to health care, financials, and industrials, are these stocks set up for a rally?
|1 yr||3 yr||5 yr||10 yr||2018||2019||2020||2021||2022||2023|
Data as of September 30, 2023. Past performance is no guarantee of future results. Returns shown may reflect hypothetical historical performance.
Source: London Stock Exchange Group
Small-cap stocks may provide a better lens into the broader U.S. economy as their fate depends more on macroeconomic conditions. Small caps are also more sensitive to interest rates, as lending is more challenging for these firms than their larger peers. In a falling rate environment, the ability to borrow rates — essential for many smaller firms — should become easier.
Hedge Funds. As active stewards of capital, hedge fund managers can dynamically position portfolios, manage exposure levels adequately, and adapt to the macro environment. Given rate changes, inflation, and resulting market volatility don’t typically happen in unison, navigating these changes presents challenges, but also creates opportunities for managers to capitalize on. Across countries and regions, as the changes are digested, macro strategy opportunities in markets like fixed income, foreign exchange, commodities, and emerging markets may arise.
The Impact of a Fed Pivot
Conversely, sticky inflation may prompt the Fed to keep rates higher for longer. And while markets are pricing in the possibility of rate cuts in 2024, Fed officials continue to reiterate their mandate to pricing stability and have left open the possibility of future rate hikes as they try to manage inflation back to their 2% target.
The sectors and asset classes that outperformed during the rising rate cycle will change as the Fed approaches its terminal interest rate. To navigate today’s shifting geopolitical and macroeconomic landscape, professional advice is crucial. The global economy remains vulnerable due to still-high inflationary pressures and interest rate hikes designed to decrease prices. Given the added uncertainty in the Middle East, the Fed’s next moves will need to be carefully considered.
- BEA, June 2022 - Personal Income and Outlays
- BEA, September 2023 - Personal Income and Outlays
- Federal Reserve Open Market Committee September 2023
- Board of Governors of the Federal Reserve System, October 19, 2023. Opening Remarks Vice Chair, Philip Jefferson
- Federal Reserve Bank of Dallas. October 9, 2023. “Financial conditions and the monetary policy outlook.”
- WSJ Pro Central Banking, Oct. 20, 2023.” Transcript: Philadelphia Fed President Patrick Harker Discusses the Economic Outlook.”
- Board of Governors of the Federal Reserve System, October 19, 2023. Opening Remarks Chair Jerome Powell
- WSJ, October 30, 2023. “Higher Bond Yields Could End the Fed’s Historic Rate Rises.”
- U.S. Energy Information Administration. What countries are the top producers and consumers of oil?
- NYU, Stern. January 2023. “Historical Returns on Stocks, Bonds and Bills: 1928-2022.”
- Bloomberg, October 23, 2023. “Ackman, Gross Abandon Bearish Bond View with Yields Bouncing Off 5%.”
- Cohen & Steers. “Unlocking value: What end of rate hikes may mean for preferreds.”