If talk of interest rate increases has seemed unending, you’re not mistaken: we are in one of the most aggressive tightening cycles in 40 years. In May, the U.S. Federal Reserve raised rates for the 10th consecutive time in its fight to bring down inflation.
In less than 14 months, the federal funds rate increased by a total of 5 percentage points (500 bps) to 5.25 percent from where it stood at 0.25 percent in March 2022. The Bank of Canada has similarly increased interest rates, raising the overnight rate by 0.25 percent to 4.75 percent at the start of June.
However, in its latest rate announcement in June, the Fed held rates steady for the first time since it began its tightening cycle, though it signaled that it may still be open to future hikes. This has prompted some to ask: Are we nearing the end of the rate cycle?
Until recently, the effects of the rapid rate hikes have appeared relatively benign. One market strategist suggested that if you were to tell investors two years ago that we would be entering one of the most aggressive rate increase cycles in history, alongside inflation that would reach 9 percent in the U.S. (and 8 percent in Canada), you would think that there would be greater effects on the stock market.1 For example, one way to value an investment is by using a discounted cash flow method which looks at future cash flows: a higher discount rate should make today’s present value of future cash flows lower. Yet, in May 2023, both the S&P 500 and the S&P/TSX Composite hovered around similar levels to those of May 2021.
Glass Half-Empty or Half-Full: Are We Headed to Recession?
The regional banking sector fallout in the U.S. this past spring was a reminder that there were likely to be follow-on effects from the unprecedented speed and magnitude of the hikes. After all, these actions were intended to slow the economy. As part of the normal course in every business cycle, some businesses will collapse, making room for others to grow. Yet, it is somewhat confounding that unemployment levels remain at lows and consumer spending has been relatively strong. Despite the expectation for slower growth, the latest earnings season has been positive. For many months, market pundits have suggested an imminent recession, but these factors may suggest otherwise.
Equity Markets: What Happens at the End of the Rate Cycle?
If we are nearing the end of the cycle, if history is any indicator, it may be good news for the equity markets. A look back at past tightening cycles shows that equity markets have historically performed well in the year after the final rate increase. Similarly, analyses show that the markets have rallied in the months after a pause.
However, in the near term, a resilient labour market and more sticky inflation, recently driven by service sector growth and the housing market, could contribute to keeping interest rates elevated — all of which are carefully being watched and likely to influence future rate decisions.
Of course, from our perspective as we manage assets for the long term, the challenge for investors is ignoring the day-to-day noise and continuing to position assets for when we will eventually need to access our capital — sometimes a decade or two into the future, or more, depending on your timeline. For many investors, longer-term returns are the only ones that matter. Though we may all appreciate some respite from the volatility of the past two years, consider also that buying when prices are lower is one of the best ways to improve longer-term results. Keep perspective and continue looking forward.
