Last week, the Federal Reserve delivered a hawkish signal, leaving markets with the expectation that rate cuts will be paused in JanuaryThis change in outlook has broad implications for major asset classes, and analysts are closely monitoring how the pause in monetary easing could affect everything from equities to commoditiesAs a major global player, the Fed's stance has an outsized influence on financial markets, and its actions—or in this case, its inaction—have led to shifting expectations among investorsBut what does the Fed's likely decision to pause rate cuts mean for key markets? Citigroup’s global macro strategy team, led by Dirk Willer, recently released a report analyzing how various macro assets have performed during past easing cycles, particularly during the pauses in between periods of rate cuts or when a cycle endsThe findings highlight trends that could provide valuable insights for investors in the coming months.
Performance of Risk Assets During Rate Cut Pauses
The study reveals that, historically, U.S
equities tend to perform well during Fed rate cut pauses, but this performance is highly dependent on whether economic weakness will lead to a resumption of easing measuresIn essence, while stocks may initially rise in response to the halt in rate cuts, sustained upward movement hinges on whether the broader economic data deteriorates enough to force the Fed back into easing mode.
For example, the S&P 500 typically sees a short-term rally following a rate cut pause, but the bullish trend tends to falter within about a monthThis is often a signal that while the immediate outlook may appear favorable, the broader economic picture is weak enough that the Fed could be forced to resume easingA short-lived rebound, while common, is not always the caseIf the pause marks the end of the easing cycle—rather than a temporary halt—the rally in U.Sequities can extend much further, even though the degree of returns tends to be more volatile.
Looking at historical data, Citigroup highlights two instances where rate cut pauses had a lasting impact on the market: in 1989 and 1998. In 1989, a brief rally in the S&P 500 was followed by a 10% pullback after the pause
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On the other hand, during the 1998 and 2003 cycles, the market saw a more sustained three-month rally as the easing cycle endedFor the short term, at least, Citigroup sees a generally constructive environment for U.Sequities.
Treasury Yields and Bond Market Impact
For fixed-income investors, a rate cut pause typically signals an upward trajectory in yields, especially during the initial stagesCitigroup’s research indicates that the first few months of a rate pause generally see yields climb more sharply than they would during the final stages of an easing cycleOver time, however, the upward pressure on yields may ease as the broader market comes to terms with the Fed’s decisionIn the case of a rate pause towards the end of an easing cycle, Treasury yields can rise more noticeably, with an increase of 50 basis points over several months.
Given the current environment, Citigroup is not optimistic about the outlook for U.S
TreasuriesThis research aligns with the bank’s broader strategy to underweight U.Sinterest rates in global asset allocation modelsThe expectation is that the yields on U.Sdebt will continue to rise as the Fed moves closer to halting its rate-cutting cycle, with implications for fixed-income portfolios that investors will need to navigate carefully.
The Dollar’s Performance During Pauses and Rate-Cut Endings
Citigroup also finds that the end of a rate-cutting cycle is typically more favorable for the U.Sdollar than a mere pauseIf the Fed’s actions suggest that it is nearing the end of its easing cycle, the dollar tends to continue its upward momentumIn contrast, if the Fed simply pauses its rate cuts, the U.Sdollar tends to experience more volatility, often moving sideways in a range-bound fashion.
The implication for investors is that a rate-cut pause doesn’t provide the same sustained strength to the dollar as a conclusion to the easing cycle would
However, if the current pause is perceived as the last of the cycle, the dollar is likely to appreciate more significantly, reflecting increased confidence in the U.Seconomy or diminished expectations of further easing.
Gold: A Beneficiary of Pauses and Easing Cycles
One area that stands to benefit regardless of whether the Fed resumes its easing cycle or not is goldCitigroup’s research shows that gold prices generally rise during both pauses and the final stages of easing cyclesThe demand for gold is often driven by a combination of factors, including central bank purchases, inflation concerns, and geopolitical risksDuring a pause, when interest rates remain stable, gold benefits from lower opportunity costs, while during the end of an easing cycle, the precious metal often gains as a hedge against potential inflation or economic uncertainty.
Citigroup’s bullish stance on gold is reinforced by the broader context of central bank demand, suggesting that investors may continue to seek safe-haven assets in uncertain times
While gold’s performance may be tied to a variety of factors, including changes in interest rates and inflation expectations, it remains a favored asset in environments of monetary policy uncertainty.
U.Svs European Equities During Pauses
In the context of global equity markets, Citigroup finds that U.Sequities tend to outperform European stocks during a rate-cut pauseHowever, this outperformance is not without its volatilityIn instances where the easing cycle ends, the relative performance between U.Sstocks and European equities can reverse, with the latter seeing a more significant rallyIn this case, the S&P 500, a major U.Sindex, could show significant underperformance compared to the European Stoxx 50 index, which is a benchmark for European equities.
While the U.Sremains the dominant equity market, the report shows that rate cuts’ pausing or ending can shift the relative performance dynamics between U.S
and European stocks, providing potential opportunities for savvy investors to rotate their portfoliosHowever, this is a strategy that requires careful timing, as the market's direction can change rapidly based on evolving economic data and policy decisions.
Small-Cap Stocks vs Defensive Stocks
Citigroup also distinguishes the performance of small-cap stocks versus defensive stocks during a rate-cut pauseIf the pause is viewed as the end of the easing cycle, small-cap stocks tend to outperform defensive sectors like utilitiesSmall-cap stocks often benefit from the resumption of economic growth, which is typically associated with the end of a rate-cutting cycleConversely, if the pause is temporary, the relative performance of small-cap stocks can be more erratic, with these stocks trading within a range rather than experiencing sustained upward movement.
The report suggests that investors may want to lean toward small-cap stocks in anticipation of a potential economic rebound or as a means of hedging against the uncertainty of ongoing pauses in monetary policy
Defensive stocks, while providing stability, may underperform in the face of a broader economic recovery or at the conclusion of the easing cycle.
Emerging Markets: Opportunities in Arbitrage
Finally, Citigroup sees emerging market arbitrage as a potentially strong-performing strategy during a rate-cut pause, particularly if the pause is perceived as temporaryEmerging markets are often more sensitive to changes in U.Smonetary policy, and as such, they may see more favorable conditions during a pause in rate cutsHowever, if the Fed’s pause marks the end of the easing cycle, emerging market arbitrage may experience initial turbulence before eventually benefiting from improved conditions in the broader global economy.
The volatility in emerging markets that often follows shifts in U.Smonetary policy could provide opportunities for investors who are skilled at navigating these markets, especially through arbitrage strategies
Even in a scenario where the Fed pauses rather than ends its rate-cutting cycle, the outlook for emerging markets remains favorable, with opportunities for profit in the form of price misalignments between currencies, stocks, and bonds.
Conclusion
The Fed’s decision to pause rate cuts has profound implications for major asset classes, ranging from equities and bonds to commodities like gold and emerging market arbitrageCitigroup’s analysis offers a comprehensive view of how these assets typically behave during pauses in monetary policy, providing valuable guidance for investors navigating this uncertain periodWhile the initial reaction might suggest a period of stability and potential gains, the longer-term outlook will depend on the broader economic trajectory and whether the Fed will ultimately resume its easing cycle or bring it to an endInvestors should carefully assess the evolving economic data and adjust their strategies accordingly to capitalize on the opportunities presented by these changing market conditions.