The Federal Reserve (Fed) meets this week on Wednesday, January 30 to decide if they will raise the Fed Funds rate or keep it the same. We expect the Fed to pause in response to slower global growth, trade tensions, and market volatility.One and possibly two more rate hikes are possible before the end of the cycle. Yet,it is entirely possible that the Fed’s December hike may have been its last.
Financial markets and the Fed were at odds through the end of last year. U.S. stocks’ sharp decline during the fourth quarter was driven in part by the disconnect between the Fed’s and the market’s economic outlooks. Fed Chair Jerome Powell spooked markets in October by communicating that the Fed was a long way from a neutral rate, which the markets interpreted to mean several more hikes were yet to come. Chairman Powell has since adjusted his narrative. The latest commentary from him and other Fed officials has emphasized the central bank’s flexibility, data dependency, and increasing willingness to factor financial market volatility and overseas developments into rate decisions. It was just the message the market wanted to hear, and a nod to the growing possibility that the Fed may pause its gradual rate hikes.The Fed’s shrinking balance sheet has also been of concern to market participants looking for a pause in tightening. Though different from a rate hike, borrowing costs can rise when bonds that the Fed purchased through its quantitative easing program mature and proceeds are not reinvested (referred to as balance sheet runoff,unwind, or quantitative tightening). Here, the change in the Fed’s message from a balance sheet “normalization” on autopilot to one that is more flexible has helped market sentiment and increased speculation around the Fed’s short-term policy plans. Friday’s Wall Street Journal report that the Fed was considering slowing its balance sheet runoff and holding more Treasuries for longer was another positive sign for the doves.Markets are increasingly positioned for a pause. Fed funds futures are now pricing in about a 70% probability that rates remain unchanged throughout 2019.While we think another increase or two is possible this year, the Fed’s soft exit from a tightening policy is on the horizon.
The Fed’s current cycle is slightly more than three years old. According to research provider Ned Davis Research (NDR), stocks have generally responded favorably to a pause. NDR defined a pause as at least five months between rate hikes within a rate hike cycle. They found that in six such occurrences since 1963, stocks have been up an average of 1% in the three and six months after pauses. The 6% gain in the S&P 500 Index since the Fed’s rate hike on December 19 would be by far the best post-pause performance if the gains hold and the next hike is at least five months away. Regardless of what the Fed does this week, we recognize the possibility that they may be finished or nearly so, so we looked at what stocks have done around the end of Fed rate hike campaigns. Not surprisingly, we found that stocks tend to react positively. Looking at the 6 and 12 months following the final hike in the last seven rate hike cycles, the S&P 500 has risen by an average of 9% and 12%. Stocks have historically fared well in the 12 months leading up to the last hike. However, this time the S&P 500 fell 4% during the 12 months ending December 19. While the market environment has been challenging, we think recent weakness increases the chances of a positive market response post-tightening cycle. Recent stock gains suggest that investors probably recognized rate hike fears were overdone. Although the Fed may not be done, that scenario is worth considering given the market is pricing it in.If the Fed’s last hike comes this year, which is likely, that doesn’t necessarily mean a U.S. recession is near. Every cycle is different, but over the past 40 years, the average time from the last hike to recession has been nearly three years. In 1984 and 1995, it was over six years. Bottom line, we think recession within the next year or two is unlikely.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. To determine which investment(s)may be appropriate for you consult your financial advisor.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Data provided by LPL Financial, the Wall Street Journal,and Ned Davis Research.
- All investing involves risk including loss of principal.