The last visit to Table Mountain

Key points:

• A peak in US interest rates is expected to last 10 or 11 months, similar to the 2006-2007 ‘higher for longer’ period
• But the world economy looked different back then, with strong growth expectations helping markets
• The outlook is weaker now, and when rates are cut, risk assets are likely to re-price while long duration bonds could perform well

“History doesn’t repeat itself, but it does often rhyme” – Mark Twain

Cast your mind back some 16 to 17 years. Between 29 June 2006 and 18 September 2007, the US Federal Reserve (Fed) kept the key Fed Funds overnight interest rate at 5.25%. Today, market expectations are for the Fed to keep the rate at its current level of 5.5% - where it has been since 26 July - until the end of the second quarter (Q2) of 2024. The earlier period of rate stability lasted 15 months and in this cycle the expectation now is for the peak in rates to last for around 10 or 11 months. This plateau is being referred to in some quarters as the Table Mountain model, after South Africa’s famous flat-topped peak.

Back in 2006-2007, GDP growth was averaging around 2.0%. It was a soft landing of sorts. Consumer price inflation eased from around 4.5% in mid-2005 to between 1.5% and 2.5% at the end of 2006 and going into 2007. The yield curve, measured by the spread between yields on 10-year and two-year US Treasuries, was inverted for most of the period until the market started pricing in Fed rate cuts from the middle of 2007. However, it took time for that expectation of rate cuts to take hold. Looking back at the statement from the Federal Open Market Committee’s (FOMC) June 2007 meeting, policymakers saw the greatest risk as being that inflation may not moderate as expected. The statement also referenced moderating growth and an adjustment in the housing sector - but rates were unchanged.

Globally, things were a little different. China was in full growth mode, with GDP growth of between 12% and 14% during the period. But there were also similarities. The dollar was strong. The US labour market was tight with unemployment below 5.0% until the second half of 2007 (hitting a low of 4.4% in December 2006, six months after interest rates hit their peak).¹

How markets fared then

So, how did markets perform during that earlier period of ‘higher for longer’ interest rates?

The good news is that everything delivered positive returns, though there was a lot of dispersion. The Japanese equity market was the worst-performing stock index managing only a 4.5% change in price during that 2006-2007 period, while emerging markets posted huge equity returns. That was led by China, going through its super-growth phase, with its equity markets gaining by 200% during the same time span.

This in turn had a positive impact on returns from markets like Mexico, Brazil, Hong Kong, Korea, and Japan. Germany was the best performing Western equity market – even though European interest rates were rising at the time – reflecting the impact of Chinese demand on German-manufactured goods such as autos.

The core US and European markets did reasonably well during that period. The S&P 500 and the Euro Stoxx index rose by around 20% - perhaps concerns about recession were not as prevalent back then. The International Monetary Fund’s September 2006 World Economic Outlook forecast the US economy to grow by 3.1% in 2006 and 2.7% in 2007, and the Euro Area by 2.4% and 2.0%. China’s growth rate was forecast at 10.0%. Strong growth expectations prevailed, helping equity markets – a significant difference from the situation today. Current growth forecasts are for the major economies to flirt with recession in 2024 and for China to continue to struggle with its balance sheet problems.

Consistent with the positive returns from equities, bond returns were dominated by high yield markets. European government bonds, including UK gilts, posted positive returns but yields were in the 4%-5% range back then and most of the total return came from income. Shorter duration strategies did better, as yield curves were generally inverted, as they are today. Long duration bond assets only really started to perform towards the end of the period of high rates when investors started to speculate on the Fed cutting rates, which they did in Q3 2007 when there were signs of the US housing market starting to crack.

Lessons to be learned

What lessons can we learn from that period? We don’t really know how long rates will stay at the peak or, indeed, if this is the peak. But the central scenario is that they do stay on hold, until data suggests the economy is weakening and inflation is back at the Fed’s target - though interestingly, it was the growth data that forced the Fed’s hand back in 2007. Unemployment had started to increase, and the signs of a banking and housing market crisis were growing. Inflation re-accelerated at the end of 2007 and hit 5.6% by the second half of 2008.

The first lesson is that monetary policy can change quickly. Once the Fed did start to cut rates, it cut them quickly and aggressively.

High rates have helped short duration strategies in this cycle. High yield has also been a strong performer, reflecting the reality that the economy has yet to show signs of responding materially to the monetary tightening already in place. Long duration bonds have underperformed. While broad-based signs of economic weakness remain scarce and inflation remains above target, the Fed is not likely to send any signal about pivoting away from its current stance. This is clear from public comments by Fed officials.

As such, short duration, high yield, and assets like leveraged loans should continue to perform and long duration assets might struggle. In 2007, long duration bonds only started to outperform high yield towards the end of the ‘higher for longer’ period. Bonds didn’t start outperforming equities until the Fed started easing. What came after was a huge outperformance of duration relative to risk assets as the world economy fell into the spiral of balance sheet collapse known now as the Global Financial Crisis.

The second lesson, then, is that monetary policy eventually works and central banks can’t really control how that plays out. The non-linearities of higher rates leading to a weaker housing market and a global financial crisis were not in the FOMC’s outlook in mid-2007. So, a negative outcome in this cycle cannot be ruled out. There is potentially a period ahead when risk assets will significantly underperform.

The outlook for markets now

There are rhymes in history. With short rates high and yield curves inverted, it is hard for longer-dated bonds to deliver much more than their yield. In 2006-2007, investment grade credit did a bit better than government bonds, but spreads were narrow in the first part of the ‘higher for longer’ period. A year into peak rates, spreads started to move quickly higher. The level of credit spreads is higher today than it was in 2006-2007 so there is more chance of better credit returns for now, given the carry available relative to government bonds. This has been the case so far this year, with US and European investment grade outperforming relevant government bonds by 2%-3%. With spreads above underlying rates that are close to the overnight rate, short duration bonds look the best set to keep on performing for now.

For equity markets the growth outlook is weaker than it was in the earlier period. China is stuttering, removing one of the key drivers of equity performance compared to the mid-2000s, when globalisation had not fallen out of favour. The prolonged period of high rates came after a two-year 425-basis-points period of tightening by the Fed. But equity returns were generally positive. This time around the interest rate backdrop is similar but growth is weaker. That may make it harder for the core equity markets to deliver 20% returns while the Fed is keeping rates at the 5.25%-5.50% level.

Interestingly, since the Fed increased the Fed Funds Rate to 5.25%-5.50% on 26 July, global equities have delivered a negative return of more than 6% and US Treasuries have returned -3.6%. This is a different path to that seen in 2006. Leveraged growth was the zeitgeist back then, something which is not in evidence today.

Eventually, monetary tightening works. It hit the US housing market and then the financial system in 2007 and its impact worsened in 2008. It ultimately led to a sharp drop in US GDP growth in 2009. Inflation collapsed, turning negative, and the country’s unemployment rate shot up to 10%. The Fed had to cut rates aggressively in 2008, from 4.25% to 0.25% where they stayed until the end of 2015.

The Fed kept a tightening bias for three years after starting the monetary cycle in mid-2004. If we follow a similar path and rates stay on hold until mid-2024, the recession that has been long awaited could come in late 2024 or early 2025 with risk assets going through a significant period of underperformance and long duration bonds delivering above-trend returns. This could be the last visit to Table Mountain for the global economy, for now at least.

So, those investors who think a recession is coming expect that inflation will fall, rates will be cut and risk assets will re-price. There is a rhyme.

Performance data/data sources: Refinitiv Datastream, Bloomberg. Data as of 27 September 2023. Past performance should not be seen as a guide to future returns.