A perspective from E*TRADE Securities1
Last week, the Federal Reserve unofficially put the brakes on a campaign of interest rate hikes that began in December 2015. Prior to 2015, the Fed hadn’t raised rates for nearly a decade, underscoring the depths to which the US economy had fallen. Crisis-era monetary policy dictated low rates in an effort to jump-start borrowing and stimulate economic growth.
Since then, the Fed has lifted the target federal funds rate nine times—from nearly 0% to where it stands today, at a range of 2.25–2.50%.
Source: FactSet Research Systems
Now we’ve reached a fork in the road, and the direction the Fed takes could have wide-ranging implications for both the US economy and the financial markets. More on that in just a bit.
The great debate: How much is too much?
As the economy pulled itself out of the murk of the 2008 financial crisis, there was little debate about the need to raise rates. But as rates have risen, market observers have become more divergent in their opinions.
Part of the debate has been political, of course. In 2011, President Trump famously railed against the Federal Reserve’s policy of monetary easing, calling it “reckless,” while demonizing low interest rates for creating a stock-market bubble.1 After taking office, he promptly reversed course, advocating for keeping rates as low as possible.
But most discourse has centered around what constitutes “neutral” monetary policy—rates high enough to contain inflation while still allowing for economic growth. In other words, how much can the Fed lift rates without undermining the economy?
Have we arrived at neutral?
Last week, Federal Reserve Chairman Jerome Powell seemed to indicate that we’ve arrived at that Goldilocks moment. After announcing that the Fed would leave the federal funds rate unchanged, Powell struck a dovish tone: “The case for raising rates has weakened somewhat,” he said, adding that the Fed’s “policy rate is now in the range of the Committee’s estimates of neutral.”2
Not surprisingly, investors interpreted Powell’s remarks as signaling that the Fed is done hiking rates. Markets rallied, with the Dow Jones Industrial Average climbing more than 400 points last Wednesday—the same day Powell issued his remarks.
But it’s important to bear in mind that Powell backed off of his previously telegraphed rate hikes precisely because he sees headwinds to the economy.
“Financial conditions tightened considerably late in 2018, and remain less supportive of growth than they were earlier in 2018,” said Powell. “And, while most of the incoming domestic economic data have been solid, some surveys of business and consumer sentiment have moved lower, giving reason for caution.”2
So, while investors were cheering the Fed’s decision to hold interest rates steady, they may have overlooked the cautionary economic signals that ultimately drove the Fed’s decision.
Rate pauses: The historical record
What does this all mean for the markets? To get an idea, it’s instructive to look at the historical record.
The chart below shows how the S&P 500® index (purple line) has performed following pauses in Fed tightening cycles, represented by plateaus in the green line. Note that over the past 30 years, the Fed never resumed increasing rates after taking a break from rate hikes. Instead, the Fed took rates lower each time.
And since 2000, Fed pauses have foretold eventual market declines. This could be because investors were already digesting the same indicators that led to pauses in rate hikes.
FactSet Research Systems
But so far, history isn’t swaying market prognosticators. Early in January, strategists at Morgan Stanley predicted that the S&P 500 would rise 8% in 2019 if the Fed were to discontinue raising rates.3 Investors have also been weighing in—the S&P 500 is up more than 2% since the Fed’s decision on rate hikes.
Ultimately, gauging how the Fed’s wait-and-see attitude will affect the markets requires more time.
In the meantime, keep in mind the following:
• Lower interest rates support economic growth by expanding the money supply and making credit easier to access.
• To the extent that lending rates are pegged to the federal funds rate, a Fed pause could be good for commercial borrowing and the housing market—especially with spring right around the corner.
• Keep an eye on cyclical sectors. If the Fed is right about slowing growth, you may see that reflected in the industrials, materials, and consumer discretionary sectors. Low rates also tend to hurt financials. Conversely, if keeping a lid on rates helps to spur growth, some of those same sectors could benefit.
The next Fed policy meeting will be in mid-March. As of now, CME Group’s FedWatch tool pegs the possibility of a rate hike at precisely zero. A rate cut? Fed futures show a 1.3% chance of that.4
Seems like a pretty safe bet. But the Fed holds the cards.
1. “Trump Bashes Fed for Interest Rate Policy He Once Supported,” New York Magazine, July 19, 2018, http://nymag.com/intelligencer/2018/07/trump-bashes-fed-for-interest-rate-policy-he-once-supported.html
2. Board of Governors of the Federal Reserve System, Transcript of Chairman Powell’s Press Conference, January 30, 2019, https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20190130.pdf
3. “Morgan Stanley: Here's what needs to happen before we can 'blow the all clear signal' for stocks,” Business Insider, January 8, 2019, https://markets.businessinsider.com/news/stocks/stock-market-news-morgan-stanley-on-all-clear-signal-for-stocks-2019-1-1027851690
4. CME FedWatch Tool, February 6, 2019, https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html