Government Bonds  

How the world’s most influential central bank impacts markets

  • Understand why the US Federal Reserve is so important.
  • Describe the way that different factors affect both the US stock market and the US Treasury market.
  • Identify the way that interest rates affect economies and market returns.
CPD
Approx.30min

Investor sentiment

Another important factor that our analysis does not include is the impact of Fed policy on investor sentiment. Over the past two decades, central banks have provided a sort of backstop to financial markets, known as the ‘central bank put’. This was encapsulated in 2012 by then-European Central Bank president Mario Draghi when he said that the bank would do "whatever it takes" to protect the euro. Those three words became a widely used catchphrase that describes the power of central banks to turn around the fortunes of economies and markets.

Many investors may have been investing in financial markets with reduced fears over the past 20 years because they believed that asset price downturns would be alleviated by central banks. However, if investors believe that the hands of central banks are now tied because of elevated inflation and that the central bank put has effectively been suspended, sentiment could sour.

The point being, although the beginning of a Fed rate hike cycle does not seem to trigger stock market declines based on past experience, investors need to be mindful of the current context. Other factors, such as the state of the economy, stock market valuations, and investor sentiment, could still cause the stock market to take a turn for the worse.

Treasuries also delivered positive returns 

The US Treasury market tended to deliver positive total returns after the first interest rate hikes in a cycle. Out of the 21 rate hike cycles since 1974, the US Treasury market delivered a positive total return 21 times – a 100 per cent hit rate – in the 12 months after the first hike and 18 times – an 86 per cent hit rate – in the six months after the first hike.

This result may be unexpected given the inverse relationship between rate rises and bond prices, but it does make sense. Although short-term interest rates indeed tend to rise when the Fed is raising its policy rates, longer-term interest rates mainly reflect three factors: market expectations of future short-term interest rates, inflation, and economic growth.

As rising policy rates may mean lower inflation levels and slower economic growth in the future, long-term rates may ease when the Fed hikes, supporting the performance of the Treasury market. Relatively high levels of coupons and yields prevailing for much of the analysed period also acted as a cushion for Treasury investors. 

When comparing the relative performance of US stock market with US Treasury market in the aftermath of a change in Fed policy, the results are more nuanced. Out of the 21 rate hike cycles in our study, the US stock market outperformed the Treasury market 15 times – a 71 per cent hit rate – in the 12 months after the first hike and 11 times – a 51 per cent hit rate – in the six months after the first hike. This further highlights the need to consider all factors and the context of the change in policy and to consider using dynamic asset allocation that can adapt to market conditions as the rate hike cycle develops.