Deep Dive: When rate hiking ceases, will recession follow? What history says

The current Fed rate-hike cycle appears to be wrapping up. While Fed chair Jerome Powell recently said that the US central bank is likely to raise the target interest rate one or two more times in 2023, the decision of the FOMC to stand pat at its June 13-14 policy meeting has strengthened the belief of Fed watchers that Powell is nearly done hiking rates.

Equity and debt markets have been rallying since the fall of 2022, typical behavior during Fed rate-hike periods if recent history is a guide. But history also dictates that, at some point soon, investor caution is warranted.

Prior to this current rate-hike period, the Fed had launched five rate-hike programs since 1985. Four of them preceded US recessions that were coupled with significant equity and debt market declines. But not right away. In each case, the recessions took an average of 14 months after the last hike to arrive.

We are now in a sixth Fed rate-hike period. Assuming that the Fed is nearing the end of hikes, what does history say investors can expect of markets in the months ahead?

Looking back
Before the first rate hike last March, we asked whether a rising fed fund target rate was dangerous for investors (Deep Dive: Will debt and equity markets rally as the fed funds rate rises?). Logic dictates that it ought to be, since theoretically for a host of reasons, higher rates impair asset values.

The article looked at equity, high-yield bond and leveraged loan market performance during and after these five distinct Fed rate-hike periods: 1987-1989, 1994-1995, 1999-2000, 2004-2006 and 2015-2018.

As the story showed, logic didn’t hold. Equities, measured by the S&P 500, were higher at the end of all five periods. Leveraged loans, tracked by the Morningstar LSTA US Leveraged Loan Index, were higher after the three most recent periods (there was no loan index data for the first two rate-hike periods). And high-yield bonds, via the Morningstar US High-Yield Bond Index and ICE BofA US High Yield Index, were higher four times and down just 3% in the fifth instance.

We also looked at those indices one year after each period’s final rate hike. Again, bullishness reigned. The debt indices were all higher one year after each hike period ended, while the S&P 500 was higher after four of the rate-hike periods and down once, in May 2000.

That article examined data for one year following each final hike. This story looks at what transpired beyond the one-year mark.

Looking closer
US recessions followed within 18 months of the end of four of the five Fed rate-hike periods. Only the 1994-1995 period didn’t trigger an economic decline.

The four periods that led to recessions also led to bear markets that pummeled investors. All four times, equities and high-yield bonds fell below their levels when the Fed finished hiking. In two instances, the subsequent selling dragged markets below the levels they’d been at when the Fed started hiking.

We took a closer look at debt and equity index performances during and after each of the four Fed rate-hike periods that preceded recessions, this time extending to the subsequent bear markets. Here they are, one at a time:

Hike period January 1987 – May 1989

This rate-hike period includes the October 1987 stock market crash, when the Dow Jones Industrial Average fell 22.6% on Monday, Oct. 19, a drop that was preceded by a 4.6% decline the Friday before. Bad as that was, it did not derail equity market bulls as the index peaked in July 1990, the same month the US recession began. The high-yield bond index peaked a few weeks later, in August 1990.

Hike Period July 1999 – May 2000

This is the second time in the 1990s that the Fed tapped the brakes on the economy. The first Fed rate-hike period was February 1994 through February 1995, when rates rose to 5.25%, from 3.0%. As mentioned, this period was not followed by a recession

By late 1998, Federal Reserve chair Alan Greenspan had allowed the fed funds rate to decline to 4.75%. Six months later, the Fed chair launched a second rate-hike period and this time the economy and markets got the message.

Equities peaked before the Fed’s final hike, in March 2000, and high-yield bonds peaked in March 2001, the same month that a short recession began. But while the recession officially ended in November 2001, those two markets didn’t stop falling until one year later, in October 2002 and November 2002, respectively.

The leveraged loan market proved to be an outlier during this bear market. While it suffered a downturn in the May-November 2002 period, the bottom was higher than a prior bottom in November 2001, and the index’s uptrend never broke.

Hike period July 2004 – June 2006

Barely two years after the equity and debt markets touched long-term lows, the Fed began raising the fed funds rate in the summer of 2004, lifting it 17 times in two years, by 25 bps each, pushing the rate to 5.25%.

The ensuing bear market, encompassed in the Global Financial Crisis, didn’t arrive quickly. One year after the final fed funds hike in June 2006, debt and equity market indices were still roaring ahead. The cracks eventually appeared in the second half of 2007.

Rising rates impaired the balance sheets of highly leveraged investment banks, notably Bear Stearns and Lehman Brothers, and damaged the mark-to-market value of debt assets, in particular collateralized debt obligations, or CDOs, many of which lost nearly all their value as underlying real estate assets tanked. That, among other things, precipitated the GFC.

Hike Period December 2015 – December 2018

The Fed started hiking its fed funds target rate two months before equities began a sustained rise, from February 2016 through September 2018, that resulted in a 60% gain for the S&P 500. The Fed was hiking the entire time. Then, between Sept. 21 and Dec. 24, 2018, the S&P surrendered 19.8% of its value, and high-yield bonds and leveraged loans suffered mid-single-digit percent losses, before Federal Reserve chair Powell finally commented that he saw softening in the economy. Markets took this to mean the Fed wouldn’t continue its pace of rate hikes, and debt and equity indices were off to the races again.

Markets rallied until the pandemic created a clear and present danger to the global economy. Equity and debt markets plunged. They eventually recovered and went on to new highs, but not without the help of massive US government stimulus, which helped set up the inflation spike that the Fed is battling today.

Looking ahead
The US economy is often compared to a supertanker, needing miles of seaway to slow down and stop, let alone reverse course. That analogy perfectly fits the delay seen four times in the past forty years between the final fed funds hike and a recession. The damage caused by higher rates as they impair small business borrowing, consumer credit and debt portfolios takes time to flip the economy into slowing growth, or even recession.

What now? This is the picture so far:


Believing that the Fed is now nearly done hiking, if history holds, a recession and market decline may both lurk in investors’ futures. The first question is, when?

Since 1985, the average waiting period between the last hike and the onset of recession is 14 months, but we could be repeating 1994-1995, when a recession didn’t closely follow a year of hikes. If so, we might be waiting longer before the bottom drops out from under the markets.

The second question for investors is, how bad will it be? Will equity and debt markets pull back to below their levels when the Fed finished its rate hikes? Will they pull back to below their March 2022 marks, when the Fed began its latest round? Or will the markets escape a recession and a downturn? Time will tell. 

Featured image by 3rdtimeluckystudio/Shutterstock

This article originally appeared on PitchBook News