Short and Sharp – The Federal Reserve and a tale of two markets

Markets weren’t surprised. The Federal Reserve (Fed) had clearly telegraphed their decision to raise policy rates last week. But what was less expected was the Fed’s signal about future policy: another rate hike is likely this year, three more next year, plus the Fed will begin reducing the size of their balance sheet in the near future. (If you’re interested, I’ve debuted my new Central Bank Watch with audio discussions of each of the major banks’ recent actions, and the implications on markets.)

In fairness, this policy-rate projection was unchanged from the previous meeting, so it wasn’t “new news.” But after three consecutive months of lower-than-expected core inflation readings, markets had expected the forecast to be revised. And so, after having already fallen in response to soft inflation and economic activity readings, yields on 10-year and 30-year Treasurys fell even further after the Fed’s announcement.

Depressed 10-year yields matter because they indicate gloomy expectations for the pace of economic growth.  With inflation failing to rise, bond markets are worried that the Fed is on a tightening path, which will harm U.S. growth prospects.

In other words, the bond market believes that the Fed is making a policy error.

Before we get too carried away with the implications of the Fed’s policy, let’s have a look at the equity market’s response. The S&P 500 has continued to climb since the Fed’s decision, indicating a positive reaction from the stock market. The reason for this is that, from an equity market perspective, monetary policy is in a “Goldilocks” period. Economic growth is moderate, corporate profit growth is healthy, and inflation is low. Yes, last week’s inflation report was somewhat concerning, but it did bolster the idea that the Fed will be slow and gradual with normalising monetary policy. This “Goldilocks” backdrop enables both bond prices and equity prices to move higher.

Can this continue?

Much will depend on what happens with inflation and how the Fed responds. For their part, the Fed is focusing on the next few quarters when tightening labor markets are expected to put upward pressure on inflation. As a result, they are comfortable looking past the last few months’ inflation numbers.

If the Fed’s modest forecasts for growth and inflation are met, the FOMC will raise rates gradually and begin to shrink its balance sheet. In that scenario, bond yields should rise and equity markets can continue to perform well. If inflation expectations rise sharply, however, the Fed would be expected to raise rates faster and the associated bond sell-off would present a headwind for equities.

What if the bond market is correct and inflationary pressures do not pick up? If the Fed responds by keeping policy rates on hold rather than increasing them, the equity market would be given a strong boost. But if the Fed were to remain intent on normalizing policy, then low economic growth would weigh on earnings growth and very likely put a stop to further equity market gains.

With this uncertainty in mind, what is an investor to do? Risky assets are close to highs and central bankers around the world are becoming less supportive, so it’s hard to argue that conditions are as favorable as they were a few months ago. Although I think there is further room to run for the equity market rally, at these valuations – and with the uncertainties I just described – I see the rally running out of steam. Against that backdrop, I’d suggest maintaining the equity overweight, but consider more bond-like equities and high dividend stocks. And certainly, Europe over the United States. While the Fed is itself expecting to raise policy rates four more times between now and the end of 2018, the European Central Bank is unlikely to raise rates until mid- to late-2019. That is one thing I am certain about.

 

 

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