As the Fed starts cutting interest rates

The original version of this article first appeared in The Business Times. 

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The US Federal Reserve is finally ready to embark on a new trajectory. It will cut the target Fed funds interest rates at its next Federal Open Market Committee on 18 Sep, setting rates that will determine the risk-free rate in the financial markets.

This is likely to have multiple orders of impact through global financial markets, including currencies of major economies through a weakening US dollar and the value of real asset pricing, such as real estate.

Memory’s still fresh

Just a short while ago, higher interest rates didn’t quite sound like a problem. As we cast our minds back to the beginning of 2022, the fed fund rates were firmly set at near zero. It wasn't until March of that year, that the central bank initiated its first rate hike in the cycle, which was followed by 10 more increases that eventually brought rates up to 5.25-5.50%. 

For more than a year now, the Fed has been on hold, keeping interest rates at their highest level in 23 years. This high level of interest rates has been a burden to some, but a boon for others. Bank depositors and money market fund investors are flocking into cash and cash-like instruments with a record level of liquidity, which had been sitting on the sidelines for long.

Money market funds, which are the typical haven for liquid assets generating high risk-free interest rates in the US, have a record US$6 trillion and more of money sitting on the sidelines and with falling interest rates are likely to be looking for a new home. 

History lesson

We look back at past cut and hike cycles since 1990, when the Fed started setting a target interest rate to determine what impact it has on key markets and asset classes. 

Remarkably, starting in August 1991, the Fed rates first dipped below the threshold of 5.50%. Over the course of 33 years (or 383 months), we have spent a mere 21 months above this level. In the current cycle, we have remained at the 5.25-5.50% threshold for 13 months. It goes to show how rare this period of high interest rates has been in the past several decades.

To put historical data into perspective, here’s what an average hike cycle looked like since 1990: An average hiking cycle ended in 15 months, during which the Fed announced nine increase actions of 34 basis points or 0.34% each. 

The most recent rate hike cycle was of normal length, lasting 16 months, but was one of the most aggressive (ever) hike cycles by magnitude – with an average of 0.48% across 11 hikes. 

By the number of hikes, the 2022-23 cycle was second only to the one when former Fed chair Alan Greenspan was at the helm, who oversaw the institution’s 17 hikes between 2004 and 2006. Despite the numerous decisions, each hike during Greenspan’s time was rather gradual, rising at an average of 0.25% at a time. This slowest cycle spanned 24 months and ended up putting rates to 5.25% from the 1.0% level. 

Turning to the cut cycles, they typically lasted a shorter 14 months. The average cut was understandably greater, at 36 bps (0.36%), perhaps since rate cuts were precipitated by some form of crisis. Examples are the dot-com bubble bursting, the Global Financial Crisis and the shock of the Covid-19 pandemic. The fed funds rate fell to virtually zero in two of those episodes, and, in the case of the GFC, the near-zero rates stayed there for almost seven years.

Outperforming assets amid rate cuts

During this period of rate cut cycles, it is interesting to see how some of the major asset classes performed. 

Typically, fixed income assets fare well, benefitting from the rise in bond prices amid the falling interest rates. In particular high yield bonds and emerging market bonds that were at higher spreads on interest rates have more dramatic falls and therefore generate higher returns. 

Also, risk-on assets that benefit from falling interest rates tend to outperform, namely emerging market equities and small cap equities as the risk premium is reduced and valuation expansion occurs. 

Not all rate cycles are the same

The context of a cut or the economic background that drives the Fed’s monetary policies matters, given that not all rate cut cycles are the same. 

The reason many people have been calling for Fed rate cuts from last year and have consistently been getting it wrong is because of the resilience of the US economy. 

Now, we are seeing a relatively strong growth momentum sustaining in the US economy with an almost goldilocks scenario of strong employment during a period of inflation easing from a stubbornly high level. 

The most recent inflation data support the Fed embarking on an extended rate cut cycle, however, it will also be data dependent going forward as it was patiently waiting for inflation to come down and resisting all market pressures for the Fed to cut rates since last year.   

Remember, the Fed, unlike most central banks around the world, is tasked with a dual mandate of keeping unemployment and inflation at bay. Now, it is the inflation that is showing signs of slowing down and the stage has been set for rate cuts. Concerns over rising unemployment are looming, though, to have further convinced the Fed that now is the right time to act.

The US economy is clearly cooling from a period of strong growth. However, it is not necessarily slowing at a rapid pace, or likely to enter a recession any time soon. This means, that if the economy continues to surprise on the upside, while the market is expecting and has already priced in some meaningful rate cuts, it is highly probable that the Fed has time on its side in needing to cut rates rapidly or cut to an aggressively low level. 

The question remains whether the Fed will ever return to zero or near-zero rates, unless a major crisis occurs. It is highly unlikely that aggressive quantitative easing will be necessary in most scenarios.

This suggests that the recent experiences of a double whammy of aggressive Fed cuts and quantitative easing that drove asset prices higher rapidly may not be the likely scenario this time. In fact, the Fed is likely to be cutting rates into a quantitative tightening which is still ongoing. 

What the cut by the Fed allows is for other nations including the European Central Bank with slowing inflation and growth concerns as well as major emerging market economies including China to embark on a fresh set of interest rate cuts. 

With the US dollar already weakening, this is a boon to those economies that are heavily indebted with US dollar-denominated debt as the cost of servicing falls and as the currency moves in their favour. It is also positive for countries with capital controls, such as China, that do not want a large interest rate differential with the US dollar for fear of capital flight, and this will allow them to embark on their own stimulatory rate cut cycles. 

Falling rates, weakening dollars: Who are the beneficiaries?

Emerging markets are set to be a major beneficiary. As the US interest rates fall, the rate differential between that and the EM’s narrows, leading to a strengthening of emerging market currencies. 

When it happens, many institutional investors are likely to enter EM equities without hedging – the combination of improving growth and earnings, along with stronger emerging market currencies, is expected to generate significant returns in US dollars.

One certain thing is that there will be greater uncertainty and volatility in markets. Despite the most aggressive interest rate hikes in history and a sustained higher interest rates environment, the stock markets are at historical highs. And with high valuations, there are concerns about its sustainability or ability to move even higher.

While the equity markets have remained resilient and could be a beneficiary of falling interest rates – assuming no crisis or deep recession shock, there will be strong demand for fixed income, which has had several years of underwhelming returns. 

Fixed income as a return generator and a diversifier

Boasting a starting yield of above 5% and with falling interest rates driving capital returns, fixed income is finally showing the worth of being portfolio ballast that likely dampens volatility while generating above-average returns.

Much of the short-term liquid assets may pour into higher-yielding fixed income assets and with active managers proving themselves to generate better returns in fixed income than equities, investing in fixed income funds or unit trusts could be an attractive proposition for many investors. This rings particularly true in Asia, where many seek income opportunities.

A globally diversified portfolio across asset classes, regions, and sectors allows investors to enjoy long-term wealth accumulation with lower volatility and less reason to “time” the markets, whether the Fed is hiking as we experienced in the past few years, or entering into a new cutting cycle.