What might a central bank pause mean for markets?

The Reserve Bank of New Zealand (RBNZ) and the Federal Reserve in the US both increased interest rates again last month.

You can never be sure, but that could’ve been the final increase from both central banks.

RBNZ projections imply as much, and while it’s unclear whether the Fed will move again, many economists believe it too has done enough.

What does this mean for investors, and will it prove to be a turning point for financial markets?

The Official Cash Rate (OCR) is now at 5.50 per cent, having increased 12 times after falling to a record low of 0.25 per cent during the pandemic.

While the highest since late 2008, the OCR is still well below the 8.25 that prevailed heading into the GFC.

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However, we shouldn’t underestimate the speed with which it has increased this time, rising 5.25 per cent in 20 months.

Before now, the biggest increase over that timeframe was a mere two per cent, and that was back in 2001.

The rise in mortgage rates over the past 18 months is the most dramatic since 1986, which is probably another reason the RBNZ is happy to pause. It will be acutely aware we haven’t seen the full effect of this yet.

In the US, the upper bound of the Fed Funds Rate (FFR) is 5.25 per cent.

That’s equal with the level it reached heading into the GFC, and we need to go back to 2001 to find a time when it was higher.

Just like here, the pace of monetary policy tightening in the US has been rapid.

The FFR has increased five per cent in 14 months, something we haven’t seen since 1981, when Paul Volcker was Fed Chair and Ronald Reagan was President.

When central banks reach the top of the interest rate cycle, that’s typically a good thing for markets.

There have been 11 examples of the Fed pausing since 1980.

On seven of those occasions the US sharemarket was higher six months later, while the odds improve to eight and nine times when looking one and two years beyond the pause.

The bond market has an even stronger track record, having delivered positive returns in the wake of a Fed pause in every example since 1980, over all those timeframes.

It’s been a similar story in New Zealand.

There are five examples of the RBNZ pausing since the OCR came into being in 1999.

New Zealand shares have averaged a 3.0 per cent return in the following six months, and moved higher 60 per cent of the time.

Over one and two years, the odds of the market being up improve to 80 per cent, with average returns of 6.1 per cent and 22.4 per cent respectively.

New Zealand fixed income has also reliably delivered positive returns after the monetary policy tightening has concluded.

In those five examples, fixed income has increased in the six, 12 and 24 months that followed. It’s typically performed better than shares during the first year, with an average return of 8.3 per cent.

These results aren’t surprising.

When central banks stop increasing interest rates, it usually means we’re heading into a tougher period economically, which is friendlier to fixed income.

While the end of a tightening cycle is also good for shares, they can sometimes experience a rocky period before ultimately bouncing back stronger.

Shares (as well as property) can still do well in these periods, but it depends on the economic climate and where prices and valuations are sitting at those points.

If we haven’t already seen the last of the interest rates hikes for this cycle, we’re very close to that point.

While this doesn’t guarantee smooth sailing for asset prices, it certainly brightens the outlook and puts things on a much sounder footing from here.

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