What does a Fed hiking cycle mean for markets?

Last week the US Federal Reserve, the world’s most influential central bank, increased interest rates for the first time since 2023.

The 0.25 per cent increase took its policy rate to a range of 3.75–4.00 per cent and it looks to have marked the beginning of another interest rate “hiking cycle”.

This is the eighth Fed hiking cycle since 1980, and just the fourth this century.

While each of those periods has been a very different time for the world economy and financial markets, there are always insights to be gained from looking into the past.

On average, those hiking cycles have lasted 16 months and we’ve seen the Fed lift interest rates by slightly more than four percentage points.

The start of a Fed hiking cycle doesn’t necessarily spell doom for the US economy or the sharemarket.

In those eight previous examples, the economy fell into recession within three years on four occasions.

Those aren’t great odds, but history suggests recessions are far from inevitable.

As for the US sharemarket, it often holds its own in the face of rate hikes.

Looking back at those examples, the S&P 500 was higher a year after lift-off on six occasions, with an average return across all eight of 5.2 per cent.

Of the two declines, one was a marginal fall of 0.1 per cent after the first move in the hiking cycle of 1983.

The other exception was the most recent hiking cycle, which began in 2022 after inflation surged to a 40-year high in the wake of the COVID-19 pandemic.

That was a tough year for US shares, with the S&P 500 falling 25 per cent from its January peak to its October low.

Rate hikes weren’t the only reason for that, but they contributed.

The Fed increased interest rates from 0.25 per cent to 5.50 per cent in less than 18 months, making this one of the most aggressive hiking cycles in decades.

The US economy proved remarkably resilient through that period, helping set the scene for the strong market rebound that followed.

More than four years later there still hasn’t been a recession.

Investor sentiment also received an unexpected boost late in 2022 with the launch of ChatGPT and the artificial intelligence boom that followed.

Markets can still perform well in the face of rate hikes, especially in the early stages of a tightening cycle.

There’s also a more positive side to the Fed’s decision that shouldn’t be overlooked.

Central banks generally raise interest rates because economies are strong, rather than weak, and those conditions don’t disappear overnight.

Consumer spending in the US remains resilient, the labour market is solid, and economic growth has continued to surprise on the upside.

Every hiking cycle is different.

This time around, a lot could be riding on the situation in the Middle East.

Energy prices have been a major contributor to the recent resurgence in headline inflation.

If tensions in the region subside and oil prices retreat, headline inflation could moderate relatively quickly, reducing the need for an extended series of rate increases.

That’s a big “if”, of course, and further escalation could have exactly the opposite effect.

Fed Chair Kevin Warsh described last week’s move as removing “a dose of accommodation”, which suggests more hikes are on the cards.

However, markets don’t see increases of the magnitude we’ve seen in some past cycles, with one percentage point of additional tightening currently expected over the next year.

History suggests they often go further than investors initially expect, but a resilient economy and the possibility of falling energy prices provide good reasons why this one could prove shorter and shallower.

As always, we’ll have to wait and see which bits of history rhyme this time.

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