What does the Federal Reserve's "Skip" mean for the market?

Last week, the Federal Reserve sent a hawkish signal, and the market expects the Fed to pause interest rate cuts in January. What does this mean for major asset classes?

On December 19, analysts from Citigroup's Global Macro Strategy team, including Dirk Willer, analyzed the performance of macro assets during previous easing cycles' pause periods in a report, distinguishing between a pause and the end of an easing cycle.

In summary, Citigroup found that U.S. stocks typically perform well, but the sustainability of the rise depends on whether economic weakness leads to a restart of policy easing; U.S. Treasury yields usually rise when the cycle pauses or ends; for the U.S. dollar, if the rate cut is merely paused, the dollar performs sideways, while if it is the last rate cut, the dollar will rise; after a pause, regardless of whether the easing cycle continues, gold prices typically rise.

Short-term positive for U.S. stocks, long-term outlook on whether easing will resume

According to Citigroup, when the Fed pauses or ends interest rate cuts, risk assets usually perform well, but the sustainability of the rebound depends on whether economic weakness leads to a resumption of policy easing.

For the S&P 500 index, in the case of a pause, stocks will rise but will only be sold off about a month later, as further easing is due to deteriorating economic data, which may put pressure on stocks. In contrast, if the pause is confirmed as the last rate cut, the rebound in U.S. stocks is more enduring, although the dispersion of returns is greater.

Historically, only during the pause in rate cuts in 1989 did the S&P 500 briefly rebound before pulling back by 10%, while in 1998 and 2003, after the end of the easing cycle, the S&P rebounded for three months. Citigroup stated that overall, the data is constructive for stocks at least in the short term.

Negative for U.S. Treasuries

According to Citigroup, for fixed-income investments, a pause in rate cuts usually leads to rising yields.

As shown in the chart below, the initial phase of a pause in rate cuts tends to result in a higher rise in yields, while the impact of rate cuts at the end of an easing cycle initially has a smaller effect on yields but subsequently leads to a more significant rise, such as a 50 basis point increase in yields within a few months.

Overall, this research is not optimistic about the outlook for U.S. Treasury yields, further confirming Citigroup's current strategy of underweighting U.S. rates in global asset allocation.

Ending rate cuts positive for the U.S. dollar

Citigroup's research shows that compared to pausing rate cuts, ending rate cuts is generally more favorable for the U.S. dollar.

If at the end of an easing cycle, the dollar will remain strong, but if it is merely in a pause period, the dollar tends to be volatile. As shown in the chart below, a pause often leads to range trading for the U.S. dollar index (DXY), while if confirmed as the end of the easing cycle, the dollar will see a more significant increase

Positive for Gold

Research shows that regardless of whether the easing cycle continues, gold prices typically rise.

The chart below shows that gold prices generally exhibit an upward trend, even towards the end of the easing cycle. This research broadly supports Citigroup's bullish stance on gold based on central bank demand.

U.S. Stocks Will Outperform European Stocks During Rate Pause

During the pause, the superior performance of U.S. stocks relative to European stocks generally continues, but it is very volatile. If it is the end of the easing cycle, U.S. stocks show a significant pullback relative to the European Stoxx 50 index, but overall, they also exhibit sideways fluctuations.

Small Caps Outperform Defensive Stocks

Citigroup points out that if the pause is confirmed to be the end of the easing cycle, small-cap stocks will outperform defensive stocks.

As shown in the chart below, if the easing cycle ends, small-cap stocks significantly outperform utility stocks. If it is just a pause, small-cap stocks tend to trade within a range relative to utility stocks. Citigroup concludes that this overall still favors small-cap stocks over utility stocks.

Emerging Market Arbitrage Performs Well

Citigroup states that emerging market arbitrage should perform well, especially if this is just a pause in the cycle.

If the Federal Reserve only pauses rate cuts, emerging market arbitrage will continue to trade well. If it is the end of the easing cycle, emerging market arbitrage will ultimately trade well, but there will initially be a sharp decline. Overall, the Fed's pause or the end of the cycle will not disrupt long-short arbitrage trading.