Post-peak interest rate environment

The surge in rising costs that followed the Covid-19 pandemic emerged in Q1 2021. Year-on-year inflation in the US climbed steadily from 2.6% in March 2021 to 9.1% in the summer of 2022, according to the United States Department of Labor. 

Inflation rose initially as a result of a mismatch between the supply and demand for goods during lockdown. This was later exacerbated when strong consumer demand and tight labour markets caused wages and the cost of services to rise

With inflation shooting up to levels not seen since the early 1980s, central banks resorted to the fastest and largest monetary tightening cycle in the past 40 years. The Fed raised its Federal Fund Target Rate (FDTR) – interest rates – from 0.25% to 5.5% in just 24 months, as seen below. This is compared to the consumer price index (CPI) – inflation – over the same period.

Historically, periods of intense monetary tightening to fight rampant inflation have caused headwinds for risky assets. The negative impact on the economy tends to dampen the market mood and corporate profits. 

The chart below shows how US equities performed before and after the final rate hike by the Fed in the past. Ahead of the final hike, performance is mildly negative to flat. However, once the last hike is delivered, the outlook for equities improves dramatically, with stocks expected to rise roughly 15% on average a year later. We should point out, though, that this performance depends on whether the delayed impact of the rate hikes causes a US recession, as highlighted by the red line. On this occasion, we believe the US could avoid a recession or only have a reasonably mild one.

US equity returns after the peak fed funds rate is reached

We believe bonds look increasingly attractive after two years of poor performance, and should be less sensitive to how the US economy performs in the coming year. 

First of all, note that bond yields and prices have an inverse relationship. If yields go down, prices go up, and vice versa.

US government bond yields are roughly 5% at the time of writing. If yields remain unchanged, an investor will see a return of 5% over the next 12 months. However, if this yield was to change by 1-2%, in either direction, its returns would be appreciably different. 

As highlighted in the table below, if yields go up by 1%, which we believe is highly unlikely, the 12-month return on the bond (including coupons) would be expected to be -2%. However, if yields fall by 1%, the 12-month return would be expected to be a considerable 12%.

We believe we’ve neared, or even reached, the peak in interest rates, and therefore expect yields to fall and prices to rise. Notably, a forecast return of 12% – should yields fall by 1% – would be greater than what cash rates are currently offering.