Could history repeat itself in the Fed’s upcoming tightening cycle?

A Fed tightening cycle will be associated with a stronger dollar and weakness in overseas risk assets, but that’s not usually the case. 

This prospect fills many with trepidation, perhaps particularly holders of riskier assets such as those in emerging markets, and those short of dollars. But is this justified?

It might seem obvious to many that a Fed tightening cycle will be associated with a stronger dollar and weakness in overseas risk assets, but that’s not usually the case. During the last Fed rate-hike cycle from the end of 2015 to the end of 2018, the Fed raised rates eight times taking the upper bound of the target rate from 0.5% to 2.5% but, rather than appreciating, the dollar fell against emerging market currencies while emerging market bonds improved considerably compared to treasuries.

It was the same during the previous cycle between 2004 and 2006 when the Fed hiked 425-bps in all. Why was this, and could history repeat itself in coming years as the Fed pushes policy rates back up? There is one school of thought that has been around for some years which is that there’s two aspects to a tightening cycle from the Fed. It relates to the fact that the Fed will likely deliver not only ‘policy shocks’ during a tightening cycle, which lift the dollar and hit risk assets negatively, but also ‘information shocks’ that can weigh on the dollar and lift risk assets.

What’s the difference between the two? Perhaps the best way to think about this is to consider the context in which the rate hikes occur. Yes, policy tightening can lift the dollar and hurt risk assets when rates rise, especially if the moves are not fully anticipated. But if these hikes occur in the context of sharply improving expectations for US – and hence global - growth then this ‘information shock’ can weigh on the dollar and lift risk assets as investors become more positive about the outlook. This information shock comes from the Fed as it provides context around the reason for the policy tightening. A number of researchers have attempted to separate out these policy and information shocks and the results tend to support the theory.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said there would be also a time aspect to this. In the run-up to the rate-hike cycle, as the Fed tapers and starts to lay out the case for rate hikes, there’s considerable room for monetary policy surprises as the market is not initially sure when the rate hikes will start and how fast the Fed will have to go. However, once the cycle starts and the rate hikes come at a steady and largely predictable pace, the monetary policy shocks recede and information shocks have a bigger role to play. What this means is that the dollar is often strong in the build-up to a tightening cycle, but weak through the period of rate hikes. Likewise, risk assets tend to suffer before the hikes start – as we saw in the 2013 taper tantrum – but recover once rate hikes get underway.

Could history repeat itself in this cycle, meaning that now might be peak time for dollar strength and risk asset vulnerability, with reversals to come as rate hikes start? Mr. Steve Barrow forecasted it would be possible, but a big difference this time is that inflation is surging and hence it is harder for the Fed to create positive information surprises. “In the past, inflation was low and tightening was all about the robust US economy. But with things very different, now we would be more circumspect about the future if inflation stays high. Of course, if inflation slumps there could be a very positive information shock, with considerable benefit to risk assets and damaging effects on the dollar. At the moment, though, we lean to the former scenario”, Mr. Steve Barrow said.