As markets and clients continue to grapple with the impact of monetary policy on their portfolios, there are four stages to the interest rate cycle, according to Richard Bernstein, of New York-based fund house Richard Bernstein Advisory.
Bernstein, a former chief investment strategist at Merrill Lynch, said: “The first stage of a rate cycle presents itself when Treasury yields are at rock bottom, the Federal Reserve’s policy stance is maximum dovishness and profit and economic growth is at or near a trough.
"In this current cycle, August 4, 2020 marked the start of stage one. With financial conditions supportive of higher inflation and economic and profit recovery, rates across the curve always increase during stage one. As RBA was throughout 2021, this is the time for maximum underweight of duration. he second stage of a rate cycle is marked by strong growth and inflation and a Fed that goes from easy (QE, low Fed funds) to less easy (tapering asset purchases) to modestly tightening (first rate hike). Like stage one, this environment is a recipe for higher rates and is generally characterized by a steeper, but overall higher yield curve.
The investor added: “During stage two, the market begins to lose confidence in the Fed’s ability to slow growth and inflation, often leading to a 'blow off the top' in Treasury yields that sends the near-term forward spread (the difference between the current three-month T-bill and its expected rate six quarters in the future) to extremes. During this phase, the Fed isn't doing enough to slow nominal growth, so long-end yields go up by more than short-end yields, a phenomenon known as 'bear steepening'."
Those stages typically occur when economic growth is robust and inflation, while rising, remains at a level not sufficiently high as to provoke concern from policy makers.
The next two stages occur when inflation starts to rise to a level central banks deem problematic.
Bernstein says: “The third stage of the interest rate cycle is marked by profit and economic growth that has begun to moderate and by a Fed that starts to aggressively tighten financial conditions. In the current cycle, the markets have now entered stage three, which is often a tricky time for investors. Inflation is high, and growth is still positive, the Fed raises rates often leaving one to assume higher yields across the interest rate curve. However, earnings and economic growth have usually peaked during this period, while the Fed has committed to slowing demand. Consequently, this phase is characterized by curve inversion; higher two-year yields than 10-year yields, otherwise known as 'bear flattening'."
He says the final stage of the rate cycle is marked by interest rate cuts.
Bernstein says: “By the time this happens, economic and earnings growth is negative and yields across the entire interest rate curve collapse. During this stage, the Fed cuts interest rates and two-year yields collapse, causing a re-steepening (known as “bull steepening”) of the yield curve. We view state four occurring sometime in 2023, as we expect the earnings recession to deepen and the effects of a year’s worth of tightening to take hold in the real economy.”
Bill Dinning, chief investment officer at Waverton, said markets are presently pricing in US interest rate cuts in 2023, even as they expect significant rate rises in the coming months.
david.thorpe@ft.com
