There have been seven bear markets over the last 43 years. The Federal Reserve has played a part in most, if not all, of those bear markets.
Before looking at the bear markets themselves, let’s look at the impact of Fed policy on the 10-year Treasury Note. During the inflation-wracked 1970s, the central bank of the United States embarked on three separate campaigns to combat the ever-escalating costs of living. Across three different tightening cycles that began at the start of three different presidencies – 1972, 1976 and 1980 – the yield traveled north of 14%.
Unfortunately, neither the tightening cycle that began in 1972 nor the one that began in 1976 did much to contain the soaring costs of products and services. Living standards suffered. Economic output waned. In essence, the U.S. struggled through stagflation – a period with rapidly declining purchasing power and anemic economic growth.
The third and final campaign to beat inflation back (1980) proved successful, if only due to the sheer scope of the endeavor. The recently appointed chairmen, Paul Volcker, sent the federal funds rate to a record high of 20 percent in late 1980. Car buying and home purchases became virtually non-existent because the cost to borrow money had journeyed through the proverbial roof. Meanwhile, the 1981-1982 recession did not sit well with politicians let alone businesses or consumers. For that matter, the third bear market in less than a decade had all but destroyed investor faith in Fed “shenanigans.”
When it comes to investing implications, then, one can should take note that rate hike campaigns to battle runaway inflation have led to sharp bearish retreats in equity prices. Most notably, in each of the 70s-style tightening cycles, bear markets began in a matter of months, not years. (See the initial three tightening cycles in the above chart.)
In the last three decades, however, a dramatically different Federal Reserve began to unfold. Whereas the Fed once agreed to a “dual mandate” for fostering stable prices and full employment, the entity’s singular prescription for meeting its goals has been the expansion of credit. In fact, nearly all of our economic growth over the least 30 years is attributable to the ability of consumers, businesses and government to borrow increasing amounts at lower and lower rates.
Revisit the chart above which chronicles the 10-year’s travels since 1984. Back then, it dropped from the 10%-plus level down to the 7% level, boosting stocks rather dramatically in the years where those borrowing costs were falling precipitously. (It did not hurt that inflation descended substantially in that time as well). Then came the December 1986 tightening cycle which sent the 10-year back up toward 8%. The fear of higher borrowing costs had a great deal to do with the 36.1% decline in stock prices as well as the Black Monday Crash on 10/19/1987.
Clearly, easy money Fed policy through decreasing the cost of credit has helped send the 10-year yield plummeting over the years – from 8% to 6% to 4% to 2%. Even the popular phrase “Don’t fight the Fed” tends to inspire risk taking whenever the Fed is employing conventional or unconventional measures.
On the other hand, look at what has transpired when the Fed withdraws stimulus (a.k.a. “de facto tightening”). The sharp increases in the overnight lending rate in 1999 required little more than 8 months before the Dow Industrials descended 31.5%. (The Dow was the baby of the benchmarks. The S&P 500 fell by 50% whereas the NASDAQ fell 76%!)
One might be predisposed to giving the Fed “credit” for tightening credit at a remarkably slow and predictable pace of just 0.25% 17 times from the 1% level between mid-2004-and mid-2006. The bear market response did not come for another 39 months. Nevertheless, the eventual increases in the cost of credit caused real estate sales to stall/decline long before ex-financial U.S. stocks began getting the message. While neither the Great Recession nor one of the worst bear market collapses on record are a function of the Fed’s tightening cycle alone – while the slow pace of tightening kept bull market dreams alive for longer than they might have otherwise – the Fed does not escape scrutiny. The relatively low cost to borrow-n-spend circa 2001-2003 coupled with the slow pace of repricing circa 2004-2006 helped create a housing bubble that was certain to burst.
So what, then, has the Fed accomplished with seven years of zero percent rate policy? For one thing, when the real price of money is negligible, borrowers (i.e., individuals, families, businesses, governments) borrow beyond their means and push the consequences out into the future. In fact, according to McKinsey, debt in industrialized nations like the U.S. has been growing at a rate of 5.3%. GDP? 2.2%. The growth of global debt versus global GDP is even more discouraging.
The only way to service ever-increasing debt with exceptionally modest economic growth is with unusually low rates. That is the big reason why market-based securities — stocks, currencies, commodities, bonds — are not sure what to make of the next Fed tightening cycle. Granted, one might be encouraged by the 39-month bull market stretch that followed the last campaign’s pace of quarter-point hikes. On the other hand, the bull market at the time had barely passed two years when the Fed acted in 2004 and the 10-year yield was at 4%. Today? The Fed has yet to act after seven years on the sidelines, the 10-year is near 2.25% and the bull market is more than six-and-a-half years old.
It follows that the Federal Reserve is unlikely to have as much room to raise its overnight lending rate and it may not have enough time before inverted points along the yield curve, a bear market, a recession or all of the above. A quarter point move at every meeting? Risk assets would likely have a conniption fit. One quarter point bump every other meeting if data is supportive? Potentially better. One eighth of a point every meeting or every other meeting? Obviously more desirable.
Here’s what it comes down to, then. The slower the pace of the Fed campaign, the greater the duration of the current bull in stocks.
Those momentum players who are looking to wring out gains from higher borrowing costs can look to regional banks. The SPDR KBW Regional Banking ETF (KRE) has never looked better relative to the S&P 500 SPDR Trust (SPY).
On the flip side, those of us who do not believe the economy is as strong as the October jobs report seemed to indicate expect more Fed-induced volatility. I continue to maintain a 60% (mostly large-cap domestic), 25% bond (mostly investment grade) and 15% cash/cash equivalent mix for the majority of Pacific Park Financial’s moderate growth and income clients.