A version of this article published on May 23rd incorrectly identified the author of the research note. The article has been corrected.
The Federal Reserve’s tightening cycle might be closer to its peak than policy makers —and stock-market investors — think, says one analyst.
“While the Fed pronounces its monetary tightening as being at early stage and gradual, the facts on the ground beg the question of whether we could be much closer to the peak of the rate tightening phase,” wrote Solomon Tadesse, head of equity quant strategies at Société Générale, in a note last week.
Currently, the Fed funds rates is at 1.50% to 1.75% after six quarter-percentage point rates hikes, with the central bank expecting the gradual tightening path continue beyond 2020.
Normally, that would suggest that equity markets have a few more years to enjoy the expanding economy and rising earnings that would support prices.
Indeed, the so-called dot-plot suggest the policy makers expect two more rate increases this year and several more over the next two to three years. Meanwhile, investors are split on whether the Fed might end up delivering three rate increases in 2018.
Tadesse argues that considering only nominal tightening from zero to 1.75%, and ignoring years of quantitative easing that pushed the “implicit” true underlying rate—also known as “shadow rate”— below zero is the wrong way to calculate the overall degree of tightening.
The so-called “shadow rate” was constructed by economists Jing Cyntia Wu and Fan Dora Xia to reflect the effect of the Fed’s unconventional easing measures. As the chart below shows, the rate bottomed in May 2014 at negative 2.99%.
So, even before the first rate increase in 2015, monetary policy tightened by about 300 basis points as the Fed stopped its monthly bond purchases. Therefore, while the nominal fed-funds rate stand near 1.7%, “the degree of monetary tightening in the current cycle stands at 4.7 [percentage points], which is in line with the peak rates of tightening cycles in the post-inflationary era of the 70s and early 80s,” Tadesse said.
By the same token, the degree of the last monetary easing was 8.25 percentage points—when nominal Fed funds rates peaked at 5.25% in 2006 and fell to shadow rate of negative 2.99%.
Tadesse then applied a monetary tightening to monetary easing ratio, or MTE, using a historical average of the past several cycles (0.66% in this case) to forecast at what rate this cycle is expected to peak.
Doing a simple back-of-the-envelope calculation, he estimates that rates would peak at about 2.5% or 75 basis points above the top of the current range, which could be delivered over the next six to twelve months.
This projection is also in line with the Fed fund futures market, which is currently predicting that rates over the next 12 months would be at around 2.5%.
Tadesse notes that the peak of the tightening cycle precedes the onset of recession by about six months and as such “it calls for major rotations in investment strategy positioning, generally a move from aggressive, pro-growth strategies to the more defensive ones.”
As seen from the chart above, quality and value stocks do relatively poorly in the six months before the peak, but outperform significantly six to twelve months after the peak.
“Our analysis shows that we might be at the late stage in the ongoing rate cycle currently. This requires a realignment of strategies toward achieving a significant defensive posture,” Tadesse wrote.