AOR Update (Podcast): Not All Hiking Cycles Are Created Equal

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In this episode of Talking Markets, Jeff Schulze, Head Investment Strategist at the Franklin Templeton Institute, walks us through the latest Recession Risk Dashboard reading. Eleven of 12 indicators are currently green, putting recession odds at a modest 15%. He also covers September’s softer jobs report, why the Fed may take a patient approach with potentially one final hike in December, and the 130-basis-point rise in the 10-year Treasury yield, which he believes are driven by real yields, not inflation fears. Jeff also touches opportunities in non-US equities and emerging market bonds after a Fed hiking cycle begins, plus a potential seasonal tailwind following the midterm elections.

Transcript

Host/John Przygocki: Welcome to Talking Markets with Franklin Templeton. I'm your host, John Przygocki, from the Franklin Templeton Global Marketing Organization. As a forward-thinking asset manager, Franklin Templeton leverages cutting-edge strategies and deep industry insights to unlock opportunities to help grow wealth. We’re your trusted partner for what's ahead.

I'm here today with Jeff Schulze for our monthly conversation focused on the current state of the United States economy. Jeff is the Head Investment Strategist with the Franklin Templeton Institute. The Institute is a research-centric organization at Franklin Templeton focused on delivering unique macroeconomic and capital markets insight to our clients. Jeff, thank you for joining me this afternoon and welcome to the studio.

Jeff Schulze: Always good to be here, John.

John Przygocki: All right, Jeff, let's get started. First question for you. The US economy is always an important consideration when thinking about capital markets. So, let's start there. How does the economy look through the lens of the Recession Risk Dashboard?

Jeff Schulze: Well, I'm really excited to say that the Recession Risk Dashboard continues to have a very strong overall green signal. We've had no color changes throughout the summer into the fall here. And out of those 12 individual indicators, 11 are green (expansion). None of them are yellow (caution), and only one is red (recession). So, when you have a dashboard output of this nature, typically recession odds are a modest 15% over the next 12 months. So, the economy is on a pretty solid foundation at the moment.

John Przygocki: So, Jeff, the jobs report  for September was fairly weak. What's your take on that recent release?

John Przygocki: Well, it was weak across the board. Consensus expectations were for 90,000. It came in at 29,000. You had a big miss on private payrolls. You had negative revisions to the July and the August releases. Those two releases came down by a total of 60,000 jobs. Wage growth was barely positive on a month-over-month basis. And you saw a pickup of the unemployment rate.

So, yes, the labor market is not boiling. It's simmering. But it wasn't bad enough that it makes me really concerned about the labor market overall. It's a labor market that's settling into a new equilibrium, because immigration flows have dried up. You have a lot of baby boomers who are retiring early with capital markets at record highs. And, going forward,  this is just the new reality that we're going to have job releases that are going to be in the 0 to 100,000 range, at least for the rest of 2026 and into the first half of next year.

Now, there was one notable positive. You did see a pickup of the prime age labor force participation rate, which are individuals that are between the ages of 25 and 54. Back in July, this plunged by 0.6%. And today, the last release that we had, that jumped by 0.3%. So we've clawed back a lot of that downside. And, you know, we think that this erodes one of those labor market bear cases that are out there. But, yeah, it was a weak labor print. But it really doesn't change my perspective of how healthy labor is in the economy at this moment.

John Przygocki: Jeff, how about impact— that that release has on the Fed's monetary policy? Do you foresee another hike later this month?

Jeff SchuIze: I don't see another hike later this month. And when you look at Fed fund futures at the beginning of last week, they were pricing a 70% chance of a hike at the end of the month. After you got that jobs report, 22% chance.

And I think that feels about right. You still need to get CPI and PPI this month, which could change those odds. But, ultimately, with a number of FOMC members talking about patience, I think that is going to be a pretty high bar for a hike here in October. And I think when you look back at that labor report, yes, it was soft all around, but you don't really see any evidence of a wage price spiral because wage growth is really tepid.

So, I think that really allows the Fed to remain flexible and take a more patient approach to the next rate hike. Now, I do think we are going to get another rate hike. I think it's going to be December. And at that point that may be the last one of this cycle. But I think it's a pretty high bar for October.

John Przygocki: Jeff, your fourth quarter letter was just published. In that letter, you explore what the beginning of a Fed tightening cycle can mean for markets. Are all hiking cycles equal?

Jeff Schulze: Well, Wall Street has a lot of memorable phases. And what I wrote about this month is that bull markets don't die of old age. They're killed by the Fed. Usually, when you think about economic expansions and bull markets, they don't expire on a schedule. They only end when something breaks. And what usually breaks them is monetary policy that's tightened past what the economy can bear.

But I think it's important to note that the Fed doesn't end most cycles with a hike. It kills them with the hikes that have happened years ahead, and that first hike is really just the beginning of a long journey. When you have stages of tightening, you often have strong economic growth, strong earnings and positive equity returns.

So, you know, coming back to your question on, are all hiking cycles equal? Well, what often determines how much economic or market pain you have is the cumulative size of that hike cycle. When you go back to ’04 through ’06, cumulative increases of rates were 425 basis points. Back in 2022 and 2023, it was 525 basis points, and that period was the fastest pace of hiking that you've seen in 40 years. And in both of those instances, you had a bear market in equities. One resulted in a recession, which was in ’07 and ’08. The other did not in 2022 and 2023.

But the key takeaway here is that when you look at today's backdrop, Fed fund futures are pricing only 115 basis points of cumulative hikes. And if that's accurate, even if you get a little bit higher than that—but if that's accurate, it's going to be the most modest hiking cycle in history, which I think is going to limit economic damage. And it's going to keep that typical pattern after the initial rate hike intact, which is some early volatility, some multiple compression, but still strong earnings-driven gains.

John Przygocki: So Jeff, you just mentioned equity markets.  At the onset of a hiking cycle, are there any opportunities that you have landed on based on your historical analysis?

Jef Schulze: Well, if you go back to every hiking cycle since 1980, in the three months prior to that hiking cycle, the S&P 500 has gained 5.5%. After that first rate hike in the three months after, negative 0.7% returns. 

So you usually have a period of digestion. But what has me encouraged about US equities is that the S&P 500 is only up a half a percentage point in that three months leading up to September's hike. So, we've already had that digestion, and I think that will bode well as we get into third-quarter earnings season and the historically strong fourth quarter.

But I think there is an area of opportunity. I am positive on U.S. equities, as I just mentioned. But when you look at non-U.S. equities and you've had a shallow hiking cycle, that has usually been a pretty good combination. So not all hiking  are created equal.  We looked at those nine hiking cycles since 1980, and we broke them up into aggressive hiking cycles, where cumulative hikes were above 250 basis points, and modest hiking cycles, when you're below that 250 threshold.

And we're clearly in that modest hiking cycle bucket. But when you look at non-U.S. equities, the year following modest hiking cycles, you had EAFA, which is developed non-U.S. equities to give you a 13.2% return on average. And you had emerging markets give you 8.7% returns on average. So, you know, I don't think we're going to have that period of a digestion here in the US. But, historically, when the Fed just is kind of fine tuning, if you will, non-U.S. equities have joined the party and have done quite well on a relative basis.

John Przygocki: So, Jeff, thinking about a similar question, but on the fixed income side, what asset classes have historically fared well when the Fed began hiking?

Jeff Schulze: Okay. So, if we break it down into those modest and aggressive hiking cycles, and this is clearly modest by historical standpoints, short duration bonds did pretty well in those environments.

But you also wanted to take on some credit risk with high yield bonds delivering 6.1% on average, and the year following that first hike, and then emerging market bonds delivering a whopping 15.2% in that one year following that first rate hike. So, you want to be embracing some credit risk because we're earlier in the cycle. The Fed is not going to kill the cycle yet.  Just like we saw with non-US equities, emerging market bonds tended to do well also.

John Przygocki: All right, Jeff  there's another fear out there in the marketplace. And that's a focus on peak earnings for the S&P 500. Are all earnings peaks equal?

John Przygocki: Well, investors often treat a peak in earnings growth like the first rate hike: as a sign that the good times are ending. But what matters is less the peak itself than where earnings settle afterwards, which has historically been an important barometer of forward one-year returns. So, when you go back to 1980, the S&P 500 has returned 19.6% on average in the year following an earnings peak when that next year of earnings growth topped 10%. If you were below that 10% level, 6.1% returns on average, and with consensus suggesting that the peak is not only upon us, but expectations for earnings over the next 12 months is well above that 10% threshold,  we're optimistic that the markets will continue to melt higher, driven by earnings growth rather than P/E expansion, which has exactly been the story here in 2026.

John Przygocki: Okay, Jeff let's address higher long-bond yields. It certainly has been a key feature  of the markets in 2026. Why are long bond yields rising? And is there too much bond supply coming to markets with the hyperscalers funding the AI buildout?

Jeff Schulze: Well,  if you look at the 10-year Treasury, it's risen about 130 basis points from the February low. So, it's been a pretty big move overall. But I don't think it's too much bond supply coming to market. When you look at investment grade spreads, they're relatively close to the near-record tights that we saw at the end of May. So, supply may be creating a modest headwind or indigestion in the IG space (or investment grade space). But it doesn't explain why you had this massive move higher of 10-year Treasury yields. So, I think that there's more to the story  than just the hyperscalers tapping the debt markets and crowding out the Treasury.

John Przygocki: How about yields rising because of the debt sustainability fears in the United States?

Jeff Schulze: A lot of people argue that that's exactly the case here: fiscal sustainability fears or currency debasement. But the data really just doesn't bear out that story either. When you look at long-term credit default swaps on US Treasury debt, it's nearly unchanged from the late February lows,  when the 10-year Treasury was below 4%. So, that really doesn't suggest that there's panic out there.

When you decompose the rise of the 10-year Treasury yield, also, that shows you further evidence against that interpretation. So, since the late February low, the increase of the 10-year Treasury, which has jumped by close to a 130 basis points, of that 130 basis points, 90 basis points has been an increase in real yields, inflation expectations have moved up by about 20 basis points, and the term premium has increased by 26 basis points.

If this was concerns about fiscal sustainability, that term premium would be much higher, and inflation expectations would certainly be a lot higher, as investors would fear that inflation was going to be the release valve in solving the debt problem. And we're just not seeing that in the data.

John Przygocki: Jeff, you just mentioned “term premium”. What is the term premium? And is the recent rise telling us anything?

Jeff Schulze: Well, the term premium largely reflects rollover risk or uncertainty surrounding future refinancing. It tends to rise when investors lack confidence in the inflation outlook. And although the term premium has increased since 2022, it's important to remember that it's done so from a low base. It was deeply negative through much of the 2010s, because you had persistent deflation risks, you had inflation under undershoots, and you also had the Fed doing things like quantitative easing, which is buying bonds at the long end of the curve to help bring down rates overall.

Now, today, the term premium’s around 70 basis points. But when you look at it through a longer term lens, it's pretty modest. It's in line with the levels that we saw in the 2000s, but well below what you saw in the 1980s and the 1990s. So, when you put this all together, you’ve got stable long-term inflation, breakeven rates. You've got a modest term premium. This suggests that the bond market is not pricing persistent inflation or some sort of credibility shock. But real yields are doing the heavy lifting with economic growth holding up better than expected.

John Przygocki: So Jeff, let's try and summarize this. What is behind the rise in real yields?

Jeff Schulze: Well, I think part of it is the big repricing that we've seen on the path of monetary policy, right? In February the markets were pricing two and a half cuts. Today, the markets are pricing more than four total hikes. And when you look at expectations for Fed policy in July of 2027, from February to today, it's risen by 165 basis points. So, I certainly think that that's part of the equation.

But while there's no real smoking gun behind why real long-term bond yields have risen, I think it is a mix of catalysts. I think it could be stronger economic growth, but it's certainly not the bond vigilantes riding into town like a lot of people fear.

John Przygocki: All right, Jeff, let me ask you one final question on this topic. Is there any other potential explanation on why yields have been rising, not only here in the United States, but also around the world?

Jeff Schulze: Well, our belief is that bond yields should be viewed in the context of nominal economic growth. So that takes real GDP growth plus inflation. When you look at long-term Treasury yields, they've historically tracked nominal GDP rather closely. And when you look at it through this lens, today's level at 5.3% really isn't all that concerning. Nominal GDP right now is running at about 6%.

And this is the strongest persistent growth that you've seen in years. And the last comparable period that you saw this type of growth was during the 2001 through 2007 economic expansion. That was the last multi-year period where we had nominal GDP above 5%. Now when you look at that expansion, during the final four years back in 2003 to 2007, nominal GDP was close to 6%. The 10-year treasury was averaging 4.5%. And that 10-year Treasury was range-bound between that four and 5% levels, which is pretty much the same situation that we have today. And when you think about the rise of yields globally, stronger economic growth is really that answer on why you're seeing upper pressure across the board, because you've had an improvement of the global economic outlook.

Similarly, the last time that the US, Japan, the United Kingdom, the Eurozone had three-year average GDP at these levels, yields were similar to current levels. And the only standout is really Japan, where today their yields are a lot lower. So, when you look at it from this vantage point, the global rise in long-bond yields looks less like a market hiccup and more like a normalization following the period after the Global Financial Crisis.

And when we look at the 2010s, you had deleveraging. You had tepid economic growth. You had deflation risks. You had unconventional monetary policy: negative interest rate policies abroad, zero interest rates policies here. That is a very unusual economic backdrop. And I think today's higher nominal and real yield environment suggests that economic underpinned by stronger economic momentum, strong consumer spending, robust business investment—I think that's all contributing to a normalization. And I think that's a key reason why the equity markets haven't blinked with the 10-year Treasury rising by almost 130 basis points this year.

John Przygocki: Jeff, you just mentioned equity markets not blinking. Is there anything there that equity markets are telling us?

Jeff Schulze: I think the equity markets are giving us a very strong signal. I mean, if you would have asked me six months ago, where would equity markets be if you had a barrel of oil go up close to $40, you had the 10-year Treasury rise by 130 basis points, the Fed went from expected to cut two and a half times to being hiking four times, and the market was near an all-time high, I would have said you were crazy. But that's exactly where we find ourselves.

And I think the equity markets are telling us that we're going to have stronger GDP growth looking forward. We're going to have strong earnings looking forward. And we're probably on the cusp of a productivity wave from all this AI investment. And that's a reason to be optimistic when you're looking out on a 3-to-5-year time horizon, because we could be entering into a new regime and certainly a different regime than what we saw in the 2010s, following the global financial crisis.

John Przygocki: Jeff, as we look to conclude this afternoon's conversation. Do you have a closing thought for our listeners?

Jeff Schulze: I do. Investors have seen this higher rate story before. The 10-year Treasury has spiked to the high 4% range in each year following the Fed's 2022 hiking cycle. In October of ’23, the 10-year Treasury got to 4.98%; in April of ’24, 4.7%; Jan of ’25, 4.79%. So, each and every time you have seen this happen—it’s happened every year—the markets have continued to march higher. So, higher yields have been a test that the market has passed.

The other thing I'll mention is that we're entering into a strong period from a seasonality perspective The 12 months following the midterm elections going back to 1950, the average return for the S&P 500 has been 15.1% in every period since the 1950s. And there's been 19 observations. Every single period has seen a positive market return. So that tailwind is going to arrive with solid earnings growth, potentially broadening leadership and an economy, quite frankly, that still has momentum even though the Fed has now embarked on a hiking cycle.

So, John, I just want to come back to that adage that I mentioned before that “Bull markets don't die of old age. They're usually killed by the Fed.” But it's important to remember what part of the cycle we're talking about. The danger zone is late in the cycle when real rates are well into restrictive territory, the curve’s inverted, spreads are widening, leading indicators are rolling over, the dashboards being red. And right now, none of these classic signs are evident. And I don't really see a modest hiking cycle materially changing today's resilient economic backdrop.

So, if we do see that typical volatility that comes with the beginning of a Fed hiking cycle, you know, we think that it's a great opportunity for long-term investors to take advantage of.

John Przygocki: Thank you, Jeff, and, to all of our listeners, thank you for spending your valuable time with us for today's update. If you'd like to hear more Talking Markets with Franklin Templeton, please visit our archive of previous episodes and subscribe on Apple Podcasts, Spotify, or just about any other major podcast provider.