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12 19 2015 | by Victor Xing | Capital Markets

What were market reactions during past hiking cycles?

Historical precedents give mix pictures of market reactions during past hiking cycles.  Limited sample size (sustained hiking cycles are few, and the Federal Reserve had only re-gained policy independence after the 1951 Treasury Federal Reserve Accord) plus changing domestic and foreign economic factors often mean that no two hiking cycles are alike. In summary, stocks may not necessarily go down during a rate hike, dollar may actually weaken, and rates may move a lot or not much at all.
  • Aug 1977 – Dec 1980 (6% to 20%)
    • Background: easy monetary policy during prior years, oil and food price shocks (partly due to the end of Bretton Woods System in 1971), deteriorating government fiscal conditions, and overt emphasis on its maximum employment mandate by the Federal Reserve resulted in the the Great Inflation between 1965 to 1982.  Federal Reserve finally began to raise rates in 3Q 1977, under Chairman Arthur Burns, before intensifying its inflation-fighting effort under Chairman Paul Volcker – he lifted rates by 1.5% on Oct 8th 1979, before raising rates again by 2.5% (to 15.5%) later that month, and rates eventually peaked in Dec 1980 (20%)
    • Stocks: SPX began 3Q 1977 at around 100, before dipping below 90 by 3Q 1978, but it subsequently rose to 97 by 1979, and peaked at 136 by 1H 1981 (subsequent rate hikes pushed it down to 116 by 4Q 1981)
    • Rates: 10 year rate steadily rose from below 8% to 12% by 3Q 1980, but much of this was due to rising inflation expectations.  5 year rate was around the same ballpark (curve was flat)
    • Dollar (using DXY): dollar was still on a depreciation trend during the hiking cycle – DXY went from 105 by end of 1976 to 85 in June 1980.  Again, sticky inflation expectations were to blame, and it was only in subsequent years that Chair Volcker’s aggressive policies fully transmitted into the real economy.  It eventually recovered to the 105 range toward year-end 1981
    • Significance: Chair Volcker’s crusade against inflation contributed to thesavings and loan crisis, when S&L found their return on portfolios lower than the cost which they can borrow, leading to an industry-wide asset–liability mismatch
  • Apr 1988 – Feb 1989 (6.5% to 9.75%)
    • Background: the Federal Reserve acted aggressively following Black Mondayof 1987 by lowering rates from 7.25% to 6.5%.  The stock decline took nearly two years to recover, but rising concerns over inflation soon resulted in rates peaking at 9.75% (from 6.5%) on Feb 1989.  Headline CPI reached its local peak at 5.28% by May 1989, and the FOMC subsequently lowered rates as inflation began to fall
    • Stocks: SPX rose throughout the hiking cycle, but it is worth mentioning that it began at a local low at 224 on Dec 4th 1987 (little more than a month after Black Monday), which steadily rose to 307 by the time the FED stopped its rate hike
    • Rates: 10 year yield started at around 9% at mid 1988 and touched 9.5% by the end of the hiking cycle, before rallying below 8% toward year-end 1989.  5s started around 8.75% before shooting to 9.75 during the hiking cycle (curve flattened amid rate hike), and it also rallied a touch through 8% by year-end 1989
    • Dollar: DXY fell with stocks in the final two months of 1987 (from 97 to 86), before rallying into mid 1989 (when the rate hike was over)
    • Significance: the 88 – 89 hiking cycle was brief, and it was more of a reactionary response on inflation.  It did, however, lead to the recession of 1990
  • Feb 1994 – Feb 1995 (3% to 6%)
    • Background: the 94 – 95 tightening cycle was quite special – in a way that realized inflation was muted, and survey-based inflation expectations were also well-anchored.  However, rising long-term Treasury yields was interpreted by the Greenspan FED as a sign that inflation expectations were rising amid an economic recovery (10 year yield rose from 5.2% in Oct 1993 to 5.9% by year-end), and a rate hike cycle was commenced in lock-step with rising long-term Treasury yields, which peaked in 4Q 1994 at 8%.  The rate hike came to an end when 10 year yields retreated back to mid year 1994 levels (slightly above 7%)
    • Stocks: SPX began at 481 before declining to 445 (lows of 1994, a month after rate hike began), but it steadily rose to 482 before rate hike was over
    • Rates: 10s rose by about 2 to 2.5% during this period, and 5s30s yield curve flattened by 20 basis points (o.2%) – some argued that the FED’s rate hike contributed to the rising yields, but others believe it was merely a technical move in long-term yields that spooked the FED
    • Dollar: DXY was at its local (1992 – 1995) peak of 96.5 when the FED began the hiking cycle, and it steadily plunged to 83, when the cycle was over
    • Significance: this was perhaps the most technically driven FED policy reaction in recent history, and it happened during the heydays of Great Moderationwith limited impact
  • Jun 1999 – May 2000 (4.75% to 6.5%)
    • Background: after the end of the 94 – 95 hiking cycle, U.S. equity indices steadily rose, and the pace of acceleration picked up in 1996 before the dot-com bubble truly took form (and largely fended off the 1997 Asian financial crisis).  FED Chair Greenspan referred to the stock market rally as irrational exuberance, and a rate hike was subsequently commenced in June 1999 as a preemptive step against future inflation (headline CPI went from 1.38% in March 1998 to 1.97% in June 1999)
    • Stocks: SPX went from low 1300s to peak at low 1500s when the rate hike came to an end, but the dot com bubble had already began to deflate, and SPX subsequently reached mid 1100s before September 11, 2001
    • Rates: long-term borrowing cost barely reacted to the tightening cycle – 10 year yield went from 6% to peak at 6.75% (in Jan 2000), before declining back to 6% when the hiking cycle ended.  However, the yield curve flattened: 5s30s went from 45 bps to -40 bps (in May 2000), before ending around the area of 30 bps in July 2000 (curve subsequently steepened to 198 bps by end of 2002, thanks to post 9/11 rate cuts)
    • Dollar: DXY initially declined to 97 from 103 following the rate hike announcement, but the index subsequently peaked at 111, before climbing higher in 2001
    • Significance: FED’s effort to preemptively fight inflation contributed toward the burst of internet bubble
  • Jun 2004 – June 2006 (1% to 5.25%)
    • Background: as the housing boom progressively become the bubble that it came to be known, Federal Reserve officials became increasingly concerned (then San Francisco Fed President Yellen outlined her concerns in her October 2005 speech, but concluded by saying “the arguments against trying to deflate a bubble outweigh those in favor of it.”), and the Committee proceeded with a mechanical, steady rate hike from June 2004 to June 2006, at 25 basis point increments per meeting.  Unfortunately, the 2004 – 2006 tightening cycle failed to affect long-term interest rates (known as Greenspan’s Conundrum), and the relatively low borrowing cost continued to fuel the housing bubble
    • Stocks: SPX started June 2004 at 1135, and it seesawed to 1245 by the end of rate hike in June 2006, and it shot up to 1510 in the next 12 months (this was during the height of housing bubble)
    • Rates: 10yr yields went from 4.75% in June 2004 to 5.00% in June 2006 – largely unchanged (it in-fact traded firmer for much of 2005).  Nevertheless, front-end and belly of the curve reacted accordingly – 5s30s spread went from 150 bps to 10 bps – a 1.40% tightening (the curve briefly inverted between Feb and Mar 2006)
    • Dollar: DXY went from 89 at the beginning the rate hike to 86 – after briefly rallied to 92 (still a small move)
    • Significance: the FED failed to tighten financial conditions via its interest rates policy tool, and in retrospect, even forward guidance failed to affect long-term borrowing cost.  This hiking cycle provided much needed case study on the efficacy of using short-term rates to lower (or raise) long-term interest rates, and some of the take-away helped shaped the FED’s thinking and policy strategies following the financial crisis – in the form of quantitative easing
Market movements during past hiking cycles

Fed funds rate in blue, headline CPI in red.  Examples in the above text were using DXY (USD vs. basket of currencies), and the graph uses FED’s trade weighted dollar index against major currencies

Original Quora article

Next article12 18 2015 | by Victor Xing | Central Banks

What would happen if central banks cease to exist?