The State Bank of Pakistan’s (SBP’s) monetary policy is normally a hot topic amongst the investment community and at certain points in time it receives broader media coverage as well. The rate of interest is an important variable that affects consumption, investment and growth in the economy. It also influences the portfolio allocations of investors between equities and fixed income, with the relationship normally being inverse, i.e., when interest rates are higher, investors get higher returns from fixed income investments while equity valuations decline. Conversely, when interest rates decrease the return from fixed income drops and equity valuations rise. Therefore, investors prefer fixed income in higher rate environments and equities in lower rate environments. Given that the current policy rate of 13.75% is the highest since the 2008 Global Financial Crisis, it would be useful to take a look at the interest rate cycles that Pakistan has gone through over the past. For the purposes of this article we will go back approximately 30 years and look at what has happened, the characteristics of interest rate cycles, the impact it has on equity markets and whether history can be a guide as to what will happen in this cycle.
Since 1992, we have had 15 distinct cycles of rate hikes and cuts. A cycle is defined as the period of time between the first change and last change. Each tightening cycle is neatly followed by a loosening cycle and they alternate perfectly. Of the 15 cycles, the SBP was increasing rates in 8 of them (including the current one) and 7 where the central bank was reducing them. The average cycle lasts 1 year and 2 months with 4.6 rate policy decisions (number of rate hikes or cuts) per cycle. The longest cycle we have undergone was 3 years and 7 months (April 2005 to November 2008) while the shortest one occurred in March 1994 where a solitary rate cut happened. The highest discount rate we have witnessed was 20.0% in 1996 and the lowest was 6.25% in 2016 while the average has been 11.6% (9.9% during the current century). The maximum increase in interest rates during any cycle was 7.50% (April 2005 to November 2008) while the biggest reduction was 9.00% (June 1997 to January 2000). The average pause, i.e., time between the end of one cycle and the beginning of the next one is 10 months. The longest pause we saw was between November 2002 and April 2005 (2 years and 5 months) while the quickest turnaround happened in July 2001 where rate cuts commenced just one month after the last rate hike of the previous cycle.
Hikes vs. cuts
In terms of average change in interest rates, the length and number of policy decisions there is not much difference between a rate hike cycle and a rate cut cycle. The most notable difference is observed on the time lag between policy changes. On average it takes the SBP, one year and two months to start increasing rates after the last cut, however it starts reducing rates on average just 7 months after the last rate hike. This has implications for where we stand today and demonstrates the bias of central banks towards supporting growth over stabilisation at the earliest available opportunity.
The other major difference is how the equity markets behave during these cycles. On average the equity market loses 3.04% in value during a rate hike cycle with the biggest decline being -25.81% (January 2018 to July 2019). Conversely, during periods where interest rates are declining the KSE 100 index on average generates a return of +28.07%, with the biggest increase of 79.35% occurring during the July 2011 to June 2013 cycle.
Lessons for today
Now we know that history doesn’t repeat itself, but it often rhymes. In that case what is the take away for us at this point in time? The current rate hike cycle started in September 2021 and as of the last increase in May 2022 has lasted 8 months against the average duration of 1 year and 2 months. We have so far witnessed a jump of 6.75% in the rate which ranks second in terms of the sharpest hiking cycles (after the 2005-08 and 2018-19 cycles of 7.50% each) and is above the average increase of 4.4%. We have had 5 policy decisions (the pauses in January and March do not count) against the average of 4.4 hikes per cycle while the equity market has declined by 8.82% during this period. Put in the context of expected inflation over the next year and ongoing negotiations with the IMF (International Monetary Fund), we may be near the end of the current cycle. Recall that in 2008, inflation peaked at 25% while interest rates topped out at 15%. The major risk to this outlook is commodity pricing and political uncertainty which could destabilize the economy to a possible default if the safety net of the IMF is not procured. If we assume that May 23rd 2022 was the last rate hike then history tells us that the next cut cycle should occur during the first quarter of 2023.
And what should we expect from interest rates and equity markets if this is the end of the current cycle? Well on average interest rates drop by 2.6% one year after the last rate hike and a decline has been observed within 12 months after all rate hike cycles except for 1 (November 2013). Similarly, equities have generated a positive return in the 12 months following the last rate hike in all cycles except for 1 (November 2008). However that was a special case where the market remained frozen for several months and crashed when it was reopened. The average return in the year after the last rate hike is 26.7%.
For investors, it would be wise to track developments over the next 3 months. If clarity emerges on the political and economic front then a historical perspective could prove to be a valuable tool in determining asset allocation.
(The writer is an economist and portfolio manager working in Pakistan’s capital markets for the past decade)Mustafa O. Pasha, "History of interest rates in Pakistan," Business recorder. 2022-05-27.
Keywords: Economics , Financial crisis , State Bank , Monetary policy , Media coverage , Economy , Pakistan , SBP , KSE , IMF