UBS: Historically, the Federal Reserve has never raised interest rates in October before elections, and this time may be no different

UBS believes that the expectation of an interest rate hike in October is clearly overstated. Historically, the Federal Reserve has never raised rates at the October meeting close to a major election, and it suggests lowering the pricing of future rate hikes from 91 basis points to 75 basis points.

Written by: Bu Shuqing, Wall Street Insights

As the conflict between the U.S. and Iran drives oil prices up and U.S. Treasury yields reach nearly two-decade highs, market bets on another interest rate hike by the Federal Reserve in October are heating up. However, UBS warns that this expectation severely overestimates the likelihood of the Fed taking action before the midterm elections—historical data shows that since 1990, the Fed has never raised rates at the October meeting close to the November elections.

UBS analyst Simon Penn pointed out in a report on Monday morning that the market is currently pricing in about a 69% probability of a rate hike at the October 28 meeting, but he believes this assessment is significantly flawed. Penn emphasized that while the central bank claims its decisions are completely independent of political activities, it is customary to restrain actions before major political events. He advises traders to downplay the expectation of an October rate hike and to lower the cumulative rate hike pricing from the current 91 basis points to 75 basis points over the next year.

Meanwhile, UBS market analyst Nana Antiedu cited U.S. equity strategist Keith Parker's view that the sharp rise in U.S. Treasury yields has significantly pressured stock valuations, but this also means that once yields retreat, there is considerable room for a market rebound.

Historical Precedent: No Rate Hikes in October for 35 Years

In his report, Penn reviewed historical records since 1990. In the past 35 years, the Fed has only raised rates at the September meeting close to the November elections three times: in 2004, 2018, and 2022, while there has never been a rate hike at the October meeting.

The three September rate hikes each had their own context: the 2022 hike was the most aggressive, with a single adjustment of 75 basis points being the largest pre-election hike in modern history, as the Fed was fully addressing the inflation shock post-pandemic; the 2004 hike was part of a gradual tightening cycle that began in June of that year, spanning the entire election season; and the 2018 hike was pushed through despite public pressure from the Trump administration to pause rate hikes.

In all other election years—including 1992, 1994, 1996, 2000, 2002, 2006, 2008, 2010, 2012, 2014, 2016, 2020, and 2024—the Fed did not take any rate hike actions in September or October.

Pricing Reassessment: December Should Return to a Full 25 Basis Points

Penn believes that removing the expectation of an October rate hike does not mean the market should reprice the December meeting for a substantial hike of 50 basis points. Currently, the market's cumulative pricing for December is about 38 basis points, which he believes should revert to a full 25 basis points.

From a trading perspective, the removed October pricing should be redistributed to subsequent meetings. Penn expects that the January and March meetings will carry approximately 12 basis points and 18 basis points of pricing, respectively. Overall, he advises traders to short the long end and compress the cumulative rate hike pricing for the next year from the current 91 basis points to 75 basis points.

Yield Shock Has Severely Damaged Stock Valuations

On the equity market side, UBS's analysis is also noteworthy. Keith Parker pointed out that the sharp rise in U.S. Treasury yields has triggered a significant reset of stock valuations—since last November, as the 10-year U.S. Treasury yield has risen by about 100 basis points this year, the S&P 500 index's price-to-earnings ratio for the next twelve months has dropped by 17%, with the compression in valuations nearing recession scenario levels, comparable to the 1994 rate hike cycle.

Historical experience shows that if interest rates stabilize without significant tightening (with annual rate hikes below 100 basis points), the S&P 500 index typically achieves double-digit returns in the following year; however, if entering a full rate hike cycle (with annual rate hikes exceeding 100 basis points), historical stock market returns often flatline or even turn negative.

Parker believes that current stocks are more elastic to falling yields than they are at risk of further declines in yields, advising investors to prepare for a sustained high-rate environment while seizing asymmetric opportunities brought by yield declines. In terms of sector allocation, sub-industries such as semiconductors, pharmaceuticals, refining, and diversified banks score relatively high and are less sensitive to interest rates, making them attractive.

Market Bull-Bear Tug-of-War: Energy Shock and Inflation Pressure Intertwined

The core contradiction in the current market is that the U.S.-Iran conflict has pushed Brent crude oil to $106 per barrel, while the 10-year and 30-year U.S. Treasury yields have risen to their highest levels since 2007 and 2004, respectively. Whether high energy prices will lead to persistent inflation and force the Fed to extend its tightening cycle has become the central concern for traders.

A series of upcoming U.S. economic data will further test these concerns. If economic growth data is strong, it will provide the Fed with greater tightening space; if inflation data exceeds expectations, it will strengthen the rationale for further rate hikes.

Goldman Sachs also pointed out that if the 10-year U.S. Treasury yield rises by about 30 basis points within two weeks or about 50 basis points within a month, the stock market often encounters significant resistance. Currently, this yield has risen by 28 basis points since September 9 and has cumulatively risen by 37 basis points since August 21, approaching the critical range indicated by historical experience.

Bulls bet that yields will stabilize before borrowing costs further erode the stock market. If energy prices peak and geopolitical conflicts show signs of easing, there is a strong possibility of a market rebound. However, if energy prices remain high and economic data continues to support Fed tightening, the pressure on the market may further intensify.