Historically, The Fed Pause Has Been A Good Buy. Is It Worth It?

It is usually associated with a year or more of strong stock market returns when interest rates stop rising. It's a riskier cycle since everything is moving at a faster pace.

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Maybe the Federal Reserve is done raising policy rates after a year of fighting inflation. In the past, monetary policy pauses have provided great buying opportunities for US stocks. However, this time around, there are a few key considerations.

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After a three-month pause, the S&P 500 Index has returned 6.9%; 18.9%; and 34.7%; based on data going back to the late 1980s. As a result of recent banking sector jitters, investors may be inclined to maintain equity exposure despite a compound annual return of 11.1% over the past four decades. The Dow still rose 15 months after the Fed pressed pause in 2006, and Lehman Brothers fell 27 months after it pressed pause. In the long run, the Fed typically breaks something, but it usually takes time. 

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Rallying after a pause

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In the months following the peak of the Fed policy rate, stocks tend to rally

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It's time for investors to make another tough choice. As a result of the Fed's dovish hike last week, the Fed raised the Fed funds target range by 25 basis points to 4.75% to 5%. Jerome Powell emphasized the risks to the US economy with the rate hike as the banking turmoil threatened to limit credit availability to an unpredictably high degree. That may be the last increase of the cycle, Powell and colleagues suggested. There is still a very good chance of a peak before the end of the year, even if it is not in March.

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Should you buy stocks or play the averages? Complications abound

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As we approach the end of a significant hiking cycle, lower risk-free rates seem to be the most obvious driver of strong returns. Prices-earnings ratios tend to rise when the Fed pauses. Theory (analytical models incorporate lower risk-free rates, increasing future cash flows' present value) and practical ones. For months, falling equity risk premiums were enough to offset rising risk-free rates, effectively preventing the dot-com bust and sustaining P/Es. Essentially, if you believe there is more room for the sovereign debt rally to run, stocks may do well. 

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Inflation is a rarity at this point in time, so a pause is unlikely. There’s only one other example of a pause when the policy rate was so low on a real basis as it was in 1989 when the index was up 4.7% year-over-year. It is possible that policymakers will have to stay at this level for the foreseeable future in order to maintain the inflation mandate despite the pause. When hikes end but cuts don't follow shortly after, it's difficult to be excited.

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It's also crucial to consider market timing if inflation suddenly recedes without a recession despite the optimists' predictions. The Fed pivot has been missed by traders this cycle, unlike previous cycles. Compared to the fed funds rate (upper bound), two-year notes yield 127 basis points less, and ten-year notes yield 163 basis points less than the fed funds rate (upper bound). As a result, there may not be much near-term juice left in this rally due to the unprecedented sample size.

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With risk-free rates declining and P/E ratios rebounding, October may have been an excellent time to invest in equity funds. S&P 500 trades below 3,600 when 10-year note yields peak.  

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Lastly, we have earnings to consider. Historically, the economy has never been in an earnings recession while the Fed was still hiking a significant amount of rates, according to Harvard economist Robert Shiller. It usually takes some time for earnings to decline after the pause. It makes a lot of sense for the Fed to end its campaign when companies still have some gas in the tank and EPS growth often coincides with margin expansion. It seems that in a typical economy, that's what makes post-pause returns so special.

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In this cycle, earnings are already in recession, and some strategists predict a deeper recession to come. Many companies posted unsustainably strong earnings during the Covid-19 pandemic due to government stimulus and unusual shifts in consumption habits. A deteriorating earnings picture is easy to imagine when you add the Fed's unprecedentedly rapid policy tightening to the mix.

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The pace of revisions to Wall Street forecasts is often more telling than the forecasts themselves, but bottom-up estimates still suggest earnings will bounce back in the second half of the year. Since companies have been steadily reducing outlooks for several quarters now, they are largely a function of sell-side projections. There may be further revisions to the downside during the earnings season that begins next month.

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Several aspects of this cycle seem to be unfolding ahead of schedule. This makes sense, given the fast-paced nature of the policy rate hikes and the way financial markets operate today. This could also contribute to the reason why this episode seems a bit out of place in historical terms.  

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Stocks and Treasury markets pivoted in October instead of waiting for the Fed to pause, and savvy traders took advantage of the movement. The trade was missed by investors who waited until the actual pause took place. Companies' earnings foundations are chipping away because of unforeseen shocks, but the economy isn't necessarily breaking yet.