Don’t Fight The Fed, 1994 Edition

Submitted by Nicholas Colas of DataTrek Research

How much is 2018 like 1994? The most notable common factor: a US Federal Reserve regularly hiking interest rates with no end in sight. After that, the story gets complicated. We were in the business in 1994; our full thoughts on this “then and now” comparison below.

One of the most vivid recollections I have after 30 years on Wall Street is April 18th 1994. I covered the auto industry for Credit Suisse at the time, and everything I had recommended over the last 3 years had gone straight up. But on that day, the Fed hiked rates for the third time that year – 75 bp in total since January. All of a sudden, cyclicals were out of fashion. And no one wanted to hear about autos.

Things didn’t get any better for the remainder of the year. The Fed went again in May and August, by 50 basis points each. Then the capper… A 75 bp move in November. For the year as a whole, Fed Funds rose from 3.0% to 5.5%. Needless to say, auto stocks had a rough time.

Since it has become fashionable to compare markets today to 1994 given the Fed’s more aggressive posture of late, let’s dig a little deeper into the analogy. A few points here:

#1. US stocks were actually higher on the year in 1994, but barely so. On a price basis, the S&P 500 declined by 1.5%, but dividends brought the total return to 1.3%.

#2. The rapid-fire increases in Fed Funds allowed the central bank to essentially go on hold from 1995 to 1999. Rates peaked at 6.0% in April/May 1995. After that they remained range-bound between 4.6% and 6.0% until April 2000.

Remember how Chair Jay Powell enthused about Alan Greenspan’s constancy during the mid-late 1990s in his Jackson Hole speech in August? That stretch of do-nothing rate policy only came after the flurry of increases of rates in 1994. Perhaps Powell sees the current environment as his “1994” – get rates to neutral (3.0% or so) and then go on autopilot…

#3. US stocks more than doubled from 1995 to 1997. S&P returns were 37.2% (1995), 22.7% (1996) and 33.1% (1997). No, we don’t think 2019 – 2021 will resemble this experience, however… The chief reason is that long-term interest rates fell from 7.9% in November 1994 to 5.7% in December 1997. That is a discount rate tail wind we don’t expect to see this time around.

#4. One other way 1994 is like 2018: 10-year Treasury yields spiked when the Fed made it clear short rates were on their way higher. Ten-year Treasuries started 1994 with a 5.7% yield. By December, they were 7.8%. As mentioned in the previous point, they did decline after that.

#5. Just as now, 1994 began the year with a very low VIX reading of just 11.7. It closed March at 20.5. By December 1994 it was 13.2 and didn’t move convincingly over 20 until 1997.

Two takeaways from this brief history lesson:

  • First, 2018 has been a lot easier on US stocks than 1994 because the rate of change in Fed Funds is much slower. The odds of a 50 or 75 bp move at an FOMC meeting (commonplace in 1994) are low. If inflation picks up dramatically, that may still happen. But it is neither our nor the Fed’s base case.
  • Second, the 1994 experience refutes the notion that rapid Fed Funds increases always cause a recession. Yes, we worry about rising deficits because the 1990s playbook clearly shows that narrower budget gaps keep long-term rates on the right path (lower). But “Don’t fight the Fed” is an aphorism that needs a very large asterisk next to it.

Summing up: 2018 is enough like 1994 to take one key lesson to heart. Expect more volatility, to be sure. But look beyond the current Fed rate cycle.