10.26.2022 The equity downturn has reversed over the past week on the prospect the Federal Reserve is nearing “maximum tightening.” The S&P 500 has spiked nearly five per cent over the last week and the 10-year rate, which peaked at 4.22 per cent, has cascaded nearly 15bps. Meanwhile, the Federal Open Market Committee (FOMC), muzzled by its quiet period leading up to its November meeting, has been unable to talk the market down with what we affectionately call its “Federal Open Mouth Policy.” But what Fed rhetoric did air last week was remarkably conciliatory, suggesting it is ready to pause tightening next year.

Fed Funds futures suggest investors are pricing in maximum tightening, since futures match the FOMC’s dot plots of governors’ median rate path projections. Beyond the mid-2023 peak, the Fed anticipates a steeper slide in the overnight rate compared to current investor pricing. Unless the Fed ratchets up its tightening plans, peak tightening is priced in.

Fed Funds Futures vs The FOMC "Dot Plot" graph

What does this mean for equities? History has shown that the S&P 500 tends to rise following peak tightening. Looking back over the last 12 tightening cycles dating back to 1973, this year’s 22+ per cent drawdown is the second-worst tightening cycle return among them. On average, the equity benchmark gained 5.4 per cent over the subsequent six months and 7.2 per cent over the subsequent 12 months following peak Fed Funds. Equities fell in four out of the 12 cycles 12 months out. However, 1973 was exceptional, with the S&P 500 falling an additional 30.5 per cent in the subsequent 12 months. It should be noted that even though peak tightening is priced in, based on Fed Funds futures trading we’re not expected to hit peak tightening until May 2023.

Forward Returns from Last Hike graph

While equity risk taking has improved from a monetary perspective, we continue to monitor the dollar to confirm the trend. The dollar has fallen about two per cent over the last two weeks. We would like to see the greenback fall through its 50-day moving average and trend toward its 200-day moving average to confirm the trend. A downward shift in dollar momentum would signify an opportunity to increase global equity market risk.

Detailed Dollar Chart