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

Amidst soaring oil prices and near-20-year highs in US Treasury yields driven by the US-Iran conflict, market bets are rising on another Federal Reserve rate hike in October. However, UBS warns that this expectation significantly overestimates the likelihood of the Fed taking action before the midterm elections—historical data shows that the Fed has never raised rates at its October meeting, close to the November election, since 1990.

UBS analyst Simon Penn noted in a report Monday morning that the market is currently pricing in a 69% probability of a rate hike at the October 28 meeting, but he believes this assessment is significantly flawed. Penn emphasized that while central banks claim their decisions are completely independent of political activity, restraint in the lead-up to major political events is a common practice. He advised traders to downplay their expectations for an October rate hike and lower their cumulative rate hike pricing from the current 91 basis points to 75 basis points over the next year.

Meanwhile, UBS market analyst Nana Antiedu, citing US equity strategist Keith Parker, pointed out that the sharp rise in US Treasury yields has significantly suppressed stock valuations, but this also means that once yields fall, there is considerable room for a market rebound.

Historical precedent: No interest rate hike in October in 35 years

In its report, Penn outlined historical data since 1990. In the past 35 years, the Federal Reserve has only raised interest rates at its September meeting, close to the November election, three times: in 2004, 2018, and 2022. A rate hike at its October meeting has never occurred.

Each of the three September rate hikes had its own background: the 2022 rate hike was the most aggressive, with a single adjustment of 75 basis points, the largest rate hike before an election in modern history, when the Federal Reserve was fully engaged in dealing with the inflationary shock after the pandemic; the 2004 rate hike was part of a gradual tightening cycle that began in June of that year and lasted throughout the election season; and the 2018 rate hike was forcibly pushed forward against the backdrop of 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 Federal Reserve did not raise interest rates in September or October.

Pricing Reassessment: December should see a return to the full 25 basis points

Penn believes that removing the expectation of an October rate hike does not mean the market should repric the December meeting as a significant 50-basis-point increase. Currently, the market's cumulative pricing for a December rate hike is approximately 38 basis points, and he believes this figure should revert to a full 25 basis points.

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

Yield shocks have severely damaged stock valuations.

At the stock market level, UBS's analysis is also noteworthy. Keith Parker points out that the sharp rise in US Treasury yields has triggered a significant reset in stock valuations—since last November, with the 10-year US Treasury yield rising by about 100 basis points year-to-date, the S&P 500's price-to-earnings ratio for the next twelve months has fallen by 17%, and the valuation compression is close to the level of a recession scenario, comparable to the interest rate hike cycle of 1994.

Historical experience shows that if interest rates stabilize without significant tightening (with a rate hike of less than 100 basis points within the year), the S&P 500 index typically achieves double-digit returns in the following year; however, if a full rate hike cycle begins (with a rate hike of more than 100 basis points within the year), historically, stock market returns have often been flat or even negative.

Parker believes that stocks are currently more resilient to declining yields than to the downside risk of further yield increases. He advises investors to position themselves for a persistently high-interest-rate environment while seizing asymmetric opportunities arising from falling yields . In terms of sector allocation, sub-sectors such as semiconductors, pharmaceuticals, oil refining, and diversified banking have high overall scores and relatively low sensitivity to interest rates, making them attractive.

Market Bull-Bear Game: Energy Shocks and Inflationary Pressures Intertwined

The core contradiction in the current market lies in the fact that the US-Iran conflict has pushed Brent crude oil to $106 per barrel, and the yields on 10-year and 30-year US Treasury bonds have risen to their highest levels since 2007 and 2004, respectively. Whether high energy prices will lead to persistently sticky inflation, thereby forcing the Federal Reserve to extend its tightening cycle, has become the core issue of greatest concern to traders.

A series of US economic data to be released this week will further test these concerns. Strong economic growth data will provide the Federal Reserve with more room for tightening; stronger-than-expected inflation data will strengthen the case for further interest rate hikes.

Goldman Sachs further pointed out that if the 10-year 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, the yield has risen by 28 basis points since September 9 and by a cumulative 37 basis points since August 21, approaching the critical range indicated by historical experience.

Bulls are betting that yields will stabilize before borrowing costs further erode the stock market, and a strong market rebound is possible if energy prices peak and geopolitical tensions ease. However, if energy prices remain high and economic data continues to support the Federal Reserve's tightening, market pressures could intensify further.

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