By Tom Garretson
To say that the Federal Reserve’s decision to raise rates was a mystifying one would be understating the case. Since the Fed last raised rates on September 26, the S&P 500 is down 15 percent, nearing bear market territory. Yield curves have flattened to new lows, with multiple segments inverting for the first time since 2007, heightening concerns about the growth outlook. Financial conditions have tightened to a degree that we rarely see outside periods of significant global stress and recessions. Economic surprise indexes for the U.S., developed markets, and emerging markets are all negative.
Lower rate hike outlook not as dovish as it appears
Source - RBC Wealth Management, Bloomberg, Federal Reserve; market data based on Overnight Indexed Swap Rates
It’s against that backdrop that the Fed chose to raise rates while delivering what has largely been interpreted by the market as a more hawkish-than-expected official statement and press conference.
In our view, the Fed missed a golden opportunity to take a pass on raising rates at this meeting, a move that would have convinced markets that it is now shifting to a truly “data-dependent” framework, signaling in no uncertain terms that policy is not on a pre-set path. This likely would have allowed markets to steady, while giving officials and investors time to assess how the previous eight rate hikes to this point are working through the economy. Instead, the Fed’s ninth rate hike risks putting this economic expansion in jeopardy, in our view.
We have long expected the Fed to pause the rate hike process around 2.75 percent; we now expect it to pause after this move. We remove the one additional rate hike we had penciled in for 2019 and expect no further rate hikes.
At first glance, the fact that the medians of the Fed’s “dot plot,” or the rate hike path projections of Federal Open Market Committee members, fell by one rate hike throughout the forecast horizon might be seen as a dovish development, as shown in the chart. However, by lowering the “longer run” estimate—or what the Fed views as the neutral rate for the economy—to 2.75 percent, that means we are now just one rate hike away from policy no longer being accommodative in the Fed’s eyes, and two away from restrictive territory. Based on the Fed’s own estimates, that second rate hike could occur in 2019. It’s no wonder the market is now pricing a rate cut in 2020, while also pricing for the likelihood that the Fed is done raising rates.
A key pain point for markets since October has been what is the neutral policy rate, and how fast will the Fed get there? The Fed’s updated forecast will do little to quell any of those fears.
When Jerome Powell was nominated for the Fed chair position, there was some trepidation in markets given his lack of formal training in economics, but given his career in private equity, some hoped that he would be more in-tune with markets. Thus far, that hasn’t proved to be the case. On each of the key quarterly decision days following Fed meetings, the market has ended the day down.
Decision day blues
S&P 500 down days on key FOMC meeting dates during Jerome Powell’s tenure
Source - RBC Wealth Management, Bloomberg; based on closing levels from intraday highs
We’re not saying that the Fed should acquiesce to every whim or desire of the market, but we believe the Fed would likely be well served by incorporating more market signals into its framework for setting policy, particularly with respect to this latest decision. While the Fed and others are uncertain about where the neutral policy rate is, the flatness of yield curves is already telling them that we’re already there. The stock market is not the economy, but all corrections, healthy or otherwise, should be taken seriously as a signal about the growth outlook for corporate earnings, and therefore the economy.
The first section of the yield curve inverts, we expect the rest to follow
Source - RBC Wealth Management, Bloomberg
We are looking for signs from the Fed that market signals are receiving greater attention before changing to a more favorable outlook.
Great, now what?
The market reaction since the meeting has been swift. The S&P 500 is down nearly five percent since the announcement, though concerns about a U.S. government shutdown and rising tensions with China are also weighing heavily, and the 10-year yield has slipped below 2.80 percent, a key level that has held since the tax cut package passed one year ago, a sign that growth expectations are fading materially.
At a minimum, we expect the usual parade of Fed officials to work to calm markets in the weeks ahead, as the next Fed meeting isn’t until January 30. Beyond rate hikes, the Fed’s balance sheet reduction plans are as big of concern—if not greater—for markets. We are also looking for the Fed to signal some flexibility in slowing the $600B per year shrinkage in balance sheet assets at a time when liquidity concerns are growing, as Powell stated that he has no concerns about the process thus far.
Markets have been sending clear signals to the Fed since October. We think the prospects for continued economic expansion depend on whether the Fed gets the message. Until we see signs that officials are more in-tune with markets, we will view the domestic economic data with greater caution. We maintain a Market Weight view of global and U.S. equities given the oversold condition of markets and reasonable valuations, and a moderate long duration bias in U.S. fixed income as we see little risk of markedly higher yields from current levels.