Has the Federal Reserve ever started a rate tightening cycle with US equities this choppy?
The short answer is a resounding “No”, based on the 30-day expected volatility of the S&P 500, as measured by the CBOE VIX Index since it was created in 1990. The FOMC’s next monetary policy decision is just 7 trading days away, and the VIX has been closing at least one standard deviation (8+ points) above its long run mean of 20 each day over the last week.
Here’s where the VIX stood heading into the last 4 rate hike cycles back to 1990:
1994 – 1995:
- February 4th, 1994 (Day of 1st rate hike): 15.3
- Average of 30 days before first hike: 11.0
1999 – 2000:
- June 30th, 1999 (Day of 1st rate hike): 21.1
- Average of 30 days before first hike: 24.6
2004 – 2006:
- June 30th, 2004 (Day of 1st rate hike): 14.3
- Average of 30 days before first hike: 16.1
2015 – 2018:
- December 17th, 2015 (Day of 1st rate hike): 18.9
- Average of 30 days before first hike: 17.2
- Day of 1st rate hike: VIX of 17.4
- Average of 30 days before first hike: VIX of 17.3
Takeaway (1): The Fed has NEVER begun a rate tightening cycle when the VIX has been more than one standard deviation (8) from its long-run average (20) over the last +3 decades. In fact, the average of the VIX both on the day of the first rate increase and 30 days leading up to it during the last 4 rate hike cycles were always below the VIX’s long run mean.
The VIX closed today at 36.5, or two standard deviations above its long-run average. While today’s selloff was particularly sharp, the average VIX over the last 30 trading days is still 27.6 or just a hair within its normal band of distributions. More importantly for the purposes of today’s discussion, the current 30-day average is a full 10 points higher than the historical mean (17.3).
Takeaway (2): there is only one example since 1990 (1999) when the Fed commenced a rate tightening cycle with the VIX above 20. In this case, volatility was elevated to the upside during the late 1990s tech stock rally. The S&P 500 was up just under 10 percent through the day before the Fed started hiking rates at the end of June 1999 as policymakers combated the excesses of the dot com bubble.
By contrast, volatility is currently elevated to the downside and the S&P has fallen by double digits (-11.9 pct) so far this year through today’s close. Even still, just last week at Chair Powell’s congressional testimony, he remained intent on raising short-term rates by 25 basis points next week to rein in inflation. Fed Funds Futures give 95.0 pct odds of that happening.
Fair enough, but will the Fed continue to plan on more rate hikes this year if US equity volatility remains this high? Here are the levels of the VIX through the last four rate tightening cycles since 1990:
February 4th, 1994 – February 1st, 1995:
- Average of 30 days after first hike: 14.6
- Average from the first to last rate hike: 14.0
June 30th, 1999 – May 16th, 2000:
- Average of 30 days after first hike: 22.7
- Average from the first to last rate hike: 23.6
June 30th, 2004 – June 29th, 2006:
- Average of 30 days after first hike: 16.1
- Average from the first to last rate hike: 13.4
December 17th, 2015 – December 20th, 2018:
- Average of 30 days after first hike: 21.6
- Average from the first to last rate hike: 14.4
- Average VIX reading for the 30 days after first hike: 18.8
- Average VIX reading from the first to late rate hike: 16.4
Takeaway: the average VIX over the entirety of rate tightening cycles back to 1990 remain within its normal band of distributions (between 12 and 28) and are usually lower than the long-run mean (20). Even with a VIX currently two standard deviations above its long-run average, Fed Funds Futures are discounting 5-7 rate hikes this year. The reason: higher energy prices from the Russia-Ukraine conflict putting further upward pressure on inflation. The flipside of this scenario is if higher energy prices cause a recession, thereby slowing the US economy and bringing down inflation on its own so the Fed no longer needs to step in.
Bottom line: the Fed has never started a rate tightening cycle with a VIX over 25 let alone two standard deviations above its long-run mean, as is the case now. FOMC policymakers may still hike rates next week, but this data shows they will be in unprecedented territory relative to historical VIX levels and that makes for an additional risk factor for US equities.