The Fed’s alchemy

Materializes its first rate hike since 2023

For the first time since 2023, the Federal Open Market Committee (FOMC) on Sept. 16 raised interest rates by 25 basis points (bps). Fed funds futures had implied a greater than 50% probability of a hike since Chair Warsh’s August 28 Jackson Hole speech. With the economy and labor market resilient and inflation stubbornly above the Federal Reserve’s (Fed’s) 2% target, it decided to tighten policy.

What should investors take from this event? Considering today’s circumstances and looking back at the five times (1994, 1999, 2004, 2015 and 2022) the Fed has started a hiking cycle since the Fed began announcing policy decisions in 1994, and the one-off hike in 1997, we believe the following are worth considering:

Expect volatility. Across the six prior periods, the average maximum drawdown for the S&P 500 Index in the 12 months after the first hike was -12.2%, led by the -22.8% drawdown in 2022.

Look for opportunities. The average three-month return was -2.3%, and the average 12-month return was +8.7%. Given a backdrop of strong earnings growth and a strong economy, we think equity investors should use selloffs to rebalance and add diversified equity exposure.

Watch for higher yields. While on average, yields tend to rise in the lead-up to a Fed rate hike, the 10-year U.S. Treasury yield has also risen an average of 26.5 bps in the 12 months after. Given attractive starting yields today (unlike the low-rate environment in 2022), we think bonds are still attractive. We have favored shorter-duration bonds, but higher rates today and potentially higher rates ahead mean that core and core plus bond mandates are also becoming attractive.

The duration of the cycle will matter. We believe the economy and companies can stomach some increase in rates. If the Fed enters a prolonged hiking cycle and pushes rates to the point of breaking things, as occurred at the end of the hiking cycles that began in 1999, 2004, and 2022, then investors will need to remain more nimble. While unknowable at the time, the 1997 one-off hike was followed by a 12-month S&P 500 Index return of 39.8%.

What comes next for the Fed?

The FOMC has two meetings remaining this year; one is in the last week of October, which lands the week before the U.S. midterms, and the last one of the year takes place in the second week of December. The Summary of Economic Projections (SEP) indicates that participants expect one more rate hike in 2026. At the press conference, Chair Warsh provided little guidance on future policy, although his comments, coupled with the SEP, were viewed as hawkish by markets.

Stephen Dover, CFA, is Franklin Templeton’s Chief Market Strategist and Head of the Franklin Templeton Investment Institute. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.

Taylor Topousis, CFA Market Strategist – Franklin Templeton Institute, contributed to this article.

Notes

Source for all data cited: Bloomberg; Analysis by Franklin Templeton Institute.

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