hands counting US dollars with calculator and digital tablet

Now that the Federal Reserve has delivered what just about everyone expected at its September meeting—another 25 basis point rate hike and the removal of a dovish keyword from its official policy statement—the bigger questions are: how long might this tightening cycle last and can the U.S. equity market handle more rate hikes?

At this stage, it’s likely the Fed will pull the trigger again in December. The probability of a 25 basis point rate hike at that meeting now stands at 71 percent, based on market expectations. If the probability remains anywhere near this elevated level, a rate hike would presumably occur. In the modern era, the Fed has always hiked rates when the market odds were 60 percent or greater, according to RBC Global Asset Management.

The outlook for 2019, however, is less clear. The market is expecting two more rate hikes while the Fed projects three.

The market is looking for another rate hike in December
Market-implied probability of a rate hike at the December 19 Fed meeting
rate hike chart 1

Source - RBC Wealth Management, Bloomberg; data as of 9/26/18

This isn’t a restricted area

U.S. equities should be able to absorb additional rate hikes if the Fed:

  • continues to proceed at a measured pace,
  • does not overreact to domestic economic trends or unwarranted outside risks, and
  • pauses or ends the tightening cycle before it shows signs of choking off economic growth.

Rate hikes typically become problematic for the U.S. equity market (and can indirectly impact other equity markets) when the Fed tightens too far, too fast and lenders begin to restrict credit availability for households and businesses in a notable way.

So far, we’re not seeing signs of this. Quite the contrary, in a recent National Federation of Independent Business (NFIB) survey of small business owners, only three percent of respondents said that all of their borrowing needs were not satisfied, which is just one percentage point above the record low, and only two percent indicated financing was their top challenge. The NFIB said, “In short, credit availability and cost are not issues and haven’t been for many years, even with the Federal Reserve raising interest rates.”

Regardless of whether two or three rate hikes materialize in 2019, RBC Global Asset Management Chief Economist Eric Lascelles believes “… monetary tightening is growing long in the tooth” and the year of “peak” tightening could be just about over. Lascelles points to the progression of this rate hike cycle. One rate hike occurred in each of 2015 and 2016. The Fed became more active in 2017, raising rates three times. It’s likely four will occur in 2018 (assuming a December hike). Two or three could unfold in 2019, and then the Fed may pause. With 2018 likely to deliver the largest number of rate hikes, the brunt of this tightening cycle soon could be in the rearview mirror.

The Fed has raised its target rate in recent years, but is still well below the two prior peaks
Federal funds rate in % (upper bound)
rate hike chart 2

Source - RBC Wealth Management, Bloomberg; data as of 9/26/18

A fundamental tenet

The economic and corporate fundamentals matter most to the U.S. equity market, not the number of forthcoming Fed rate hikes. As long as recession risks remain low, the market should be able to absorb additional interest rate increases, and the long-term secular bull phase should have more room to run. 

Although the economy is probably in a later stage of the business cycle, all six of our major forward-looking economic indicators continue to signal very low recession risks (see table below). This is important because bull markets don’t die of old age—recessions typically do them in. When these indicators start to shift to the yellow and red zones, we would be inclined to pull back equity exposure.

Major economic indicators still in expansion mode
RBC Wealth Management U.S. economic indicator scorecard

rate hike scorecard

Source - RBC Wealth Management, Bloomberg, FRED Economic Data St. Louis Fed

The indicator that is closest to moving into the yellow category is the yield curve, as measured by the spread between 12-month to 10-year Treasury yields. At only 49 basis points, it is nearly flat and well below this expansion cycle’s peak of 355 basis points in 2010.

When this spread becomes negative (inverts) with the 12-month yield exceeding the 10-year yield, it typically signals a recession is coming. But it can take many months or more than one year for a recession to materialize. During that intervening period, the equity market can deliver healthy gains, and there is usually plenty of time to make asset and sub-asset allocation adjustments in portfolios.

We will continue to monitor the yield curve and the five other indicators along with additional economic data. As they (inevitably) begin to stall out, we will become more cautious with equity allocations. At this stage, we’re still not seeing negative signs; the indicators are signaling the expansion will persist for another 12 months, at least. Therefore, we remain constructive on U.S. equities.


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