Taking Away The Punch Bowl

18/02/2011 at 12:11 pm

It was one of Mr Bernanke’s predecessors at the Fed who said that his role in setting monetary policy was “to take away the punch bowl just as the party gets going”. The current Fed chairman appears determined to wait until festivities are in full swing, but he will have to start taking away that punch at some point, and there are worries that this will leave equity markets with a sore head.

We have already seen that higher rates need not necessarily mean lower stocks when it comes to developing economies. But how has the US market reacted to post-recessionary policy tightening in the past?

In the early 1980s a hawkish Fed pushed interest rates to 20% in an effort to contain inflation. It succeeded – at the expense of a recession that saw rates fall all the way to 8.5% by December 1982. The Fed stayed its hand for a while before tightening again in May the following year to a peak of 11.75% by August 1984.

At the bottom of this cycle – from the beginning of December 1982 to the end of May 1983 – the S&P 500 returned 19.9%. And by the time rates peaked – from end May ’83 to end August ’84 – it had returned another 8.6%.

Moving on to the post-recessionary tightening cycle of the 1990s, rates bottomed at 3% (Sep ’92), began to rise in Feb ’94 and peaked at 6% in Feb ’95. And the S&P returned 17.6% while rates were held low and a further 7.4% during the period of tightening.

Finally, while the US economy didn’t experience a technical recession in the wake of the TMT / dotcom crash, it did contract in the first and third quarters of 2001 and the Fed eased policy accordingly. This time rates didn’t bottom out until June ’03 (at 1%); they stayed there until June ’04 before rising to a peak of 5.25% in June ’05.

While rates were at the bottom that time the S&P returned 20.6%, and a further 15.5% during the period of tightening.

Time for some provisos!

  • The UK had a mini tightening cycle from Feb 1994 to Feb 1995 too: the stock market returned -11% over the period.
  • The US equity market has already returned 50% since the Fed funds rate bottomed in December 2008.
  • The 1980s and 1990s were periods of exceptionally high returns for equity markets for many reasons besides the level of interest rates.

The one conclusion that it is safe to draw from all this is that investors should not necessarily expect stocks to respond to monetary tightening in a one-dimensional way. Taking away the punch doesn’t always ruin the party.

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