The stock market’s interest rate watch intensified in recent trading sessions after influential lender the International Monetary Fund (IMF) last week called on the U.S. to hold off on an interest rate hike until 2016.
The IMF wants policy patience because, it says, there remains a considerable amount of uncertainty in the inflation picture. With the warning, the IMF downgraded its 2015 U.S. economic growth forecast to 2.5%, a sizable haircut from the 3.1% rate targeted in an April release.
But the IMF’s call may ring hollow at the interest rate–setting Federal Reserve. And that means Wall Street can’t ignore several signals still pointing to potentially tighter monetary policy in coming months, including what a higher interest rate could mean for stock and bond portfolios.
Will the Fed Listen?
The Fed may have a case to move ahead independent of any peer pressure.
The IMF simply “lowered their growth estimate to where everyone else already was," says JJ Kinahan, chief strategist at TD Ameritrade. For instance, S&P Capital IQ forecasts a 2.4% growth rate for the U.S. this year. "I don't think the Fed is really concerned with what the IMF thinks. Janet Yellen indicated two weeks ago that they will raise rates by the end of the year,” added Kinahan.
Recent economic data could also light a fire under the Fed, Kinahan noted. In May, the U.S. economy gained 280,000 new jobs, more than the 220,000 figure many Wall Street economists had expected, and a considerable bump up from the slow pace of job creation that started the year. Economists were also encouraged by a pickup in wage growth, as average hourly earnings climbed 0.3% in May. That may spell more retail spending ahead. If wages accelerate too much, too soon, it could rekindle inflation fears.
"Friday's jobs report may put more pressure on the Fed to raise rates more quickly, because more jobs were created than expected and it is the first time we've seen wage growth more than 0.1%," said Kinahan.
A look at historical numbers reveals that both the Federal funds rate (the short-term instrument controlled by the Fed that influences all interest rates) and longer-term Treasury yields (the market’s projection for future interest rates) are trading at a substantial discount to their normal historical relationship to inflation, according to S&P Capital IQ.
"The Fed really wants to get back to normalcy in relation to inflation. They want to put more arrows in their quiver, so when the U.S. falls back into the recession, the Fed can lower interest rates to restimulate economic growth,” says Sam Stovall, chief equity strategist at S&P Capital IQ. “Should the economy slip into recession while interest rates are at zero, there isn't much they can do about it.”
Digging into the historical monthly average back to 1958, at a 1.8% inflation rate (which was the rate for the year-over-year increase in the April consumer price index), the Federal funds rate should be a shade above 3% and the 10-year Treasury yield should be above 4%, notes Stovall. The current 10-year Treasury yields stands near 2.4%, while the Federal funds rate is at zero to 0.25%.
Despite all the hemming and hawing in the financial markets and among market commentators, S&P Capital IQ expects an interest rate hike this year. "We are still of the mindset it will probably be in September and if not, then in December. The Fed just wants to get on the board. They are looking to recalibrate, not restrain the economy," said Stovall.
Potential Winners and Losers
"Don't get sidetracked by the IMF news. The Fed has stated they will raise rates, so have that in your expectation for this year. Start thinking about sectors that could benefit from higher rates," argues Kinahan.
Typically, banking and other financial services stocks can benefit from an interest rate hike because the spread between where they lend money and the interest rate they pay will widen, Kinahan explained.
On the flip side, "utilities could be a primary loser from higher yields. They are known for paying good dividends, but dividends become less attractive if you can get similar yield from fixed income,” he said.
TD Ameritrade clients can track the 10-year U.S. Treasury yield (TNX) and the 30-year Treasury bond yield (TYX) on TD Ameritrade charts, including an overlay of yields on the S&P 500 (SPX) (see figure 1).
"Often higher yields will initially lead to a lower S&P 500. But then the S&P 500 can go higher as financial stocks tend to benefit, and they are one of the most heavily weighted sectors in the index," Kinahan said.