Win, Lose Or ‘Pause’: Waterboarding History

At this point, it would be entirely fair to say that analysts, pundits and market participants of all stripes are beating a dead horse when it comes to torturing history in hopes of extracting some kind of meaningful signals about “what happens” to various assets following curve inversions and dovish Fed pivots.

If history hasn’t “talked” by now, it’s probably safe to say that continuing to waterboard, starve and pull the fingernails from previous cycles isn’t likely to deliver the “goods”, as it were.

When you consider all of the myriad arguments for why this cycle is in fact “different”, you come away wondering if there’s any real utility in continuing to subject history to further scrutiny.

Be that as it may, Goldman is out with 16-page note that looks at the “historical implications of a cut, stop or pause” and suffice to say the bank covers this already well-covered issue from just about every conceivable angle.

The bank begins by reminding you that markets are pricing in an exceptionally dovish evolution that is at odds with the Fed’s own projections and, for whatever it’s worth, Goldman’s house view. Here’s the chart on that:

(Goldman)

Whatever does or doesn’t happen from here, Goldman reminds you that we are in fact in uncharted territory. “Never before has the Fed had an extended pause during the hiking cycle (prior to any cuts happening) and never before has the Fed ended its hiking cycle at such low levels of interest rates”, the bank writes, rehashing something they talked about in a note out earlier this month.

(Goldman)

Despite the lack of historical analogs, Goldman explains that “investors have asked what has happened historically at times when the Fed has had a ‘dovish pivot'” which is a kind of euphemistic way of saying “because everyone is talking and/or asking about this, we’re compelled to produce a reasonably trenchant piece of analysis, irrespective of whether there’s any utility in doing so.”

After reiterating that extrapolating is virtually impossible given how “unique” the current cycle really is, Goldman takes a look at “three types of dovish Fed pivots.” They are:

1. Fed pauses of at least 6 months
2. Ends to Fed hiking cycles completely
3. Starts of Fed cutting cycles

Goldman’s house view, you might recall, is that the Fed will in fact squeeze in another hike this cycle – in other words, this is a “pause”. The bank acknowledges (as they did in at least one previous note) that were that to play out, it would be highly unusual. As the bank writes, referencing Exhibit 4 above, “only twice since 1982 has the Fed ‘paused'” where that means “not hiked for more than 6 months during a hiking cycle, then had a further hike preceding any subsequent cut.” One of those times was in 2016 – i.e., during this cycle.

Long story short, those two “pauses” are not comparable to the current backdrop. Specifically, Goldman notes that “in neither case did the economic cycle appear similar to now [which] makes identifying what might happen next by doing historical analysis of these periods likely misleading.”

Instead, the bank thinks the current setup is more akin to periods when the Fed has kept rates high “for an extended period of time”. Again, this is basically just a rehashing of a previous note and the bottom line is that both stocks and bonds tend to do well in “high and flat” policy rate periods.

(Goldman)

So, what happens if the market is right? That is, what happens if we’ve seen the last hike in this cycle?

Well, stocks do well in the subsequent year (with the tech bubble again being the outlier) even as the ISM tends to dive (as noted earlier this week). Here’s a set of visuals on that:

(Goldman)

The bank continues, noting that bonds tend to rally hard following the last Fed hike.

(Goldman)

Ok, so how about if the Fed starts cutting? What usually happens next? Because in addition to believing that the Fed is most assuredly done hiking, markets now expect cuts – and relatively soon.

On that, Goldman starts by noting that it wouldn’t be consistent with the prior two cycles and besides that, the economic backdrop isn’t comparable to previous instances of rate cuts.

“This would be strange relative to the past two cycles where pauses have materialized for more than a year before a cut came, but not uncommon compared with cycles prior to those”, the bank writes, adding that “from a macroeconomic cycle perspective, current conditions are not that similar to previous periods when cuts began: although inflation relative to trend is similar, the level remains depressed, the output gap is positive and the unemployment rate is significantly lower.”

That said, Goldman concedes that market participants may not be entirely “absurd” in their efforts to skate ahead of the proverbial puck.

“Perhaps the market getting ahead of the cutting is not absurd though, given that historically once a cut has come, it has been followed by others soon thereafter”, they continue, before reminding everyone that “the cutting cycles appear to be much faster and sharper than hiking cycles have historically been.”

(Goldman)

There’s more than a little nuance involved when it comes to documenting the historical performance of equities around rate cuts.

For one thing, Goldman writes that “since 1982 the Fed has always cut rates in advance of a recession, while prior to that it did not cut rates until it was already in one”. The explanation for that is obviously down to inflation dynamics. Of course the onset of recessions can differ timing wise from the onset of bear markets. Here’s Goldman documenting the history of rate cuts and bear markets:

Since 1982 the Fed has generally been cutting rates in every bear market while before then it was hiking rates in every bear market, likely for similar reasons as with recessions. But the timing of these cutting cycles has varied materially – in 2007 the cut has coincided with the equity peak while in 2001 cuts occurred after the peak had already been reached. Given the timing differences, equities have not always done poorly when the Fed has first cut, although this has been the case in both of the past two cycles (Exhibit 21).

Prior to the last two cycles, equities actually rose at least 20% in the two years after the first cut. However, bond yields have shown a much more consistent pattern, especially right around the cut. Both prior to and soon after it they have fallen, although in the longer term the direction has been more mixed.

In case it isn’t clear enough from the above, divining anything about where stocks are likely to go from here based purely on a torturous analysis of various historical “pauses”, “stops” and imminent rate cuts is, for the most part, an exercise in futility.

If you really wanted to, I suppose you could extract any number of punchlines from the above about the timing of Fed action (or inaction, whichever the case may be) in relation to the onset of recessions and bear markets, but I don’t see much point in that considering the fact that if you parse all of this enough, you can find pretty much any combination of policy and market performance you want to find.

It is entirely possible that all historical “analogs” have been rendered meaningless given structural factors weighing on inflation, the possibility that the whole concept of the “cycle” is to a certain extent antiquated and, perhaps most importantly, the apparent willingness of policymakers (both monetary and fiscal) to dive down the rabbit hole in pursuit of unorthodox “solutions” in a world that no longer conforms to the old models.

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