Rising US interest rates. Learnings from 2019.
Written by: Mutsumi Kagawa (Chief Global Strategist, Economic Research Institute of Rakuten Securities)
1．US stet is shakock marken by rising interest rates
September employment statistics released on the October 7 were stronger than forecast, and the unemployment rate fell (3.7% → 3.5%). The FRB is expected to raise interest rates at the next FOMC (Federal Open Market Committee) meeting, and the bond market’s interest rates have risen, causing the stock market to fall. Chart 1 shows changes in US stocks (S&P500 index), policy interest rate (the upper limit of the FF interest rate guidance target), long-term bond interest rate (10-year bond yield) and short-term bond interest rates (2-year bond yield) since July 2021. The bond market interest rates have also risen sharply as the FRB raised interest rates rapidly to curb inflation. Thus, the stock market was forced into a bear market. Interest rate hike drives down stock prices in two ways. The first is a movement to raise the discount rate of the “discounted present value of profit forecasts” which affects the stock price and it lowers the present value. The second is that cumulative effect of interest rate hikes will worsen business sentiment and increase the uncertainty about the future of business performance, causing downward pressure on stock prices. The latter may impact stocks through the July-September (Q3) financial results and guidance (earnings forecasts) to be announced this week, and the market is becoming more cautious. In fact, the IMF (International Monetary Fund) announced the latest “World Economic Outlook” on the October 11 and revised the US real GDP growth rate downward to +1.6% in 2022 and slowed down to +1.0% in 2023.
2. How the market sees the direction of the policy interest rate
How high will US interest rates go? The following shows the outlook for policy interest rates calculated in the interest rate futures market (Chart 2). It plots the FF interest rate forecasts at each FOMC meeting month. The FF interest rate currently controlled by the FRB is 3.25%. The next FOMC to be held on November 1-2 and the final FOMC of the year (December 13-14) are expected to raise interest rates by more than 50 BPS (0.5%). Then, the policy interest rate is expected to peak at around 4.68% in March 2023 and decrease in the second half of next year. Chart 2 is just the average of current market forecasts (October 12). Judging from recent inflationary trends and future business sentiment, it is expected a significant interest rate hike seems likely to happen within the year and reach the peak in the first half of next year.
I would like to pay attention to the comparison with the long-term bond interest rate (3.91%) in the bond market outlook above. The market is focusing on the reversal of the long-term bond interest rate and the short-term bond rate (4.30%) as an “inverted yield”. But the prevailing theory is that the FRB is paying more attention to the positional relationship between long-term bond rates and policy rates. In other words, at the FOMC meeting in November and December, when the policy rate is likely to reach or exceed 4%, the policy rate may match or reverse the long-term interest rate. Such a phenomenon suggests that the FRB is “overtightening (overkilling)” and is more likely to be seen as a sign of a slowdown in policy rate increases (or the long-term bond interest rates turn downward). In fact, the last FOMC meeting minutes released on the October 12 mentioned, “Some participants pointed out that it will be important to adjust the pace of further tightening with a view to mitigating the risk of a significant adverse impact on the economic outlook that in the current highly uncertain global economic and financial environment.”
3. Looking back at the last interest rate cycle and stock performance
In fact, looking back at the relationship between the interest rate cycle and stock prices in the previous cycle, we can see the market performance in which the relative position of the policy rate and the bond market rate influenced the direction of the stock price. Chart 3 shows changes in US stocks (S&P500 index) and various interest rates from 2017 to 2019. FRB raised interest rates 9 times in total from December 2015 to December 2018. The cumulative effect has lowered inflation expectations and business confidence, and bond market interest rates turned downward at the end of 2018. Then, the US stocks bottomed out when policy rates and bond market rates aligned (at the end of 2018). Thereafter, bond market interest rates declined and stock prices rose. FRB reduced interest rate in the second half of 2019 to follow the trend. We should still remember that US stocks rose more than 28% in 2019.
We should pay attention to the fact that the FRB’s “stopping interest rate hikes” at the end of 2018 led to a reversal recovery in stocks.
I would like to look back on sector (industry) selections during the period of high stock prices when policy interest rates declined from high level at that time (Chart 4). In 2019, the declining bond market interest rates had led to the biggest increase in stock prices in “high tech-related” stocks. After IT (information technology), communication services (including Alphabet and Facebook at the time) showed performance that surpassed the market average. Besides, capital goods & services and consumer goods & services that favour decline in bond market interest rates and interest rate cuts also performed well. At that time (2019), an anomaly (market empirical rule) predicted that stock prices would tend to rise “the year before the presidential election”, and the rise exceeded expectations. The year 2023 is also the year before the presidential election. I foresee policy rates to catch up with bond market rates in 2022, which is the year before. Originally, many are wary of a sign on economic recession as an “inverted yield”. However, stocks have already been factored it in and heavily discounted. On the contrary, there is possibility that next year will have “interest rates peaking out” and “high stock prices during a recession”. I have introduced the market performance of “interest rate hikes until the end of 2018 and high US stock prices in 2019” as reference for the trajectory of US stocks in 2023, which were forced into a bear market in 2022. It is true that the stock market is currently volatile. However, I would calmly assess the future and overcome this difficult situation.