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Preparing For A Rate Pause

How would you position your portfolio asset allocation if the following statements are true?

  • Interest rates to be paused for at least 5-6 consecutive central bank policy meetings followed by possible rate cuts later.

  • Inflation in the downward trajectory towards central bank's target rates.

  • Markets entering a low volatility period.

  • Market risks getting contained by intervention before risks turn systemic.

  • Talks of soft landing of leverage in the system.

An expected logical answer would be to increase risk assets such as equity in the portfolio. The points mentioned above are indeed the actual narratives surrounding the financial markets currently. The banking failures in the US could be part of a bigger rot, but they are getting contained for the immediate future by FIDC & Fed interventions. VIX is trending lower and market participants continue the talk of soft landing.

Even though RBI is ahead of the interest rate cycle having already paused the rate hikes owing to easing inflation and slowing economic growth, the mother market, the US is catching up. Fed hasn't announced a pause in its previous FOMC meeting, but the changes are high in the May 2-3, 2023 meeting. If not in the next meeting, surely on the next to next one. The market seems to be gearing up to the rate pause already, having seen some solid gains on the S&P500 & Nasdaq in the past week. India however, has recovered sooner than the US owing the RBI decision last month and seems to be leading the mother market at the moment. The trend is clear, a pause on interest rate will be cheered on by the market and needless to say, a pause by Fed will have a positive effect on rest of the world.

The pause in rates as a precursor to slowing economy, possibly leading into a recession, could be viewed with bullish and bearish lenses. We need to look at the correlation between the interest rate cycle & and the stock market to determine when the bullish undertone transforms into a bearish overtone.

Checking the correlation during 2006-2008 gives a fair idea of how the stock market has reacted to a pause in rates, to some extent even 2018-2020 gives similar vibes. The Fed paused the rates in July 2006 after hiking consecutively to tame the real-estate market boom. And unsurprisingly, the stock market sighed a relief and cheered. S&P500 rallied from 1250 to 1540, about 25%, Nasdaq rallied from 1450 to 2200, about 50% within a span of 15 months. Terrific rally? Yes indeed, but no one needs introduction to what followed, the GFC.

Fed Funds Rate vs S&P500 Correlation - 2007
Fed Funds Rate vs S&P500 Correlation - 2007

A similar correlation can be found as recently as 2018, when Fed paused rates in December 2018, when S&P500 rallied 40% and Nasdaq 50% until Covid struck in 2020. The rally gathered steam as rate cuts where subsequently announced. However this wasn't true during the 2000 Dot Com bust when stock markets cracked as soon as rates were paused. That is probably because QE was not a phenomenon back then and the excess leverage in the system that feeds on lower rates was not there. The market in 2000 took cue immediately on a rate pause. But in the post QE world that we are in today, market will cheer for a pause in rate and more so when first couple of rate cuts are announced.

Fed Funds Rate vs S&P500 Correlation - 2019
Fed Funds Rate vs S&P500 Correlation - 2019
Fed Funds Rate vs S&P500 Correlation - 2000
Fed Funds Rate vs S&P500 Correlation - 2000

If history of the post QE world is to be believed, we are likely heading into a significant rally across risky assets as the uncertainty around interest rate abate as Fed announces a pause. Now, the aftereffects of the hikes in Fed funds rate and holding onto the "higher for longer" narrative by the central banks is not possible to predict, but likely-hood of a systemic risk getting incubated and hatched is high for the near future, considering the previous episodes of central banks rising and cutting rate too late and missing the curve. So we are heading into a whipsaw. But as an investor, how do you prepare for the pause in rate hikes? Do you ride the rally that comes along with it, with the hope that you can pull out just in time before some systemic risk hits, or would you stay out, crying silently watching the index move up significantly hoping that the past will repeat? Mind you, central banks might have learned from mistakes of the past and stop the risk before it can occur as well, meaning the market chugs along nicely to new all time highs, no one can predict. But how would you act? Interesting times ahead!

PS: The blog has been inactive for almost a year now. In the previous article "A Selling Climax?", I had contemplated a bottom in stock market based on some extreme sentiment data and a benign outlook on inflation having peaked. Nifty indeed bottomed in July 2022, a month after the observation and the US few months later. Between then and now, nothing much happened to compel a follow-up article on the market which moved with a slow grind. The bond market had already priced in lower inflation in H2 2022 and the eventuality of a rate pause was ticking. Now we are close to it, this is compelling enough to get an article out. Hopefully, more articles will flow in regularly on this blog as developments gets interesting as central bank policies take center stage yet again.

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