As the Federal Reserve gathers for a hotly debated policy meeting this week, stock market jitters accompany concerns that the Fed could take away the punch bowl when the rest of the world still needs a little juice. Others think that if the Fed doesn’t act now, it will lose some credibility.
Wall Street has bristled at the perceived threat to historically cheap borrowing. But jittery investors might pause to consider this: the fact that the Fed can even debate a course that justifies higher rates now—or sometime soon—is a bullish endorsement of the U.S. economy. The Treasury yield curve is already reflecting this scenario, some analysts note.
A Coin Toss? Not Quite
Arguments in favor of a rate increase this week include improvement in the labor market, especially with the unemployment rate now standing at 5.1%. Arguments against a rate hike this week include no-show inflation, which continues to trend well below the Fed's 2% target rate. Concerns about China’s slowdown and spotty overall global economic growth—plus the subsequent equity market volatility—have been cited in recent weeks as potential “hold” factors for the Fed.
"We see a 45% chance they will start the rate-tightening cycle this week, and a 55% chance they will begin in December," says Sam Stovall, managing director of U.S. equity strategy at S&P Capital IQ.
Those are pretty even odds that do add up to short-term uncertainty for investors and the market.
"The market is not done with its volatility and might not even be done with its decline. Investors can do themselves a favor and sit on their hands and control the temptation to hit the sell button. Think about opportunities and stocks you would like to buy at a more attractive price," Stovall says.
In the stock bulls’ favor, Stovall points to the current steepness of the yield curve; it tracks the difference between longer-term Treasury yields (aka interest rates), including a 10-year Treasury note, and short-term rates, such as the three-month T-bill yield.
"If long-term rates are higher than short-term rates, that’s good,” argues Stovall. “A steep [or upward-sloping] yield curve is good for the economy and the stock market. We historically have not fallen into bear markets or recessions when the yield curve is so steep," he says.
The 10-year Treasury yield is currently around 2.18% compared with a 0.03% three-month yield. It will be important to watch if any Fed hike pushes up short-term rates much faster than long-term rates, thereby changing the shape of the curve. Read more on the Fed’s impact on the yield curve and fixed income investments.
Watch It Unfold
The CBOE Volatility Index (VIX), the broader stock market’s “fear gauge,” is elevated, holding above 25 after languishing near historic lows well below 15 for much of the early part of this year.
“There’s no reason to believe volatility will come off before the Fed meeting. While actual [Fed funds futures] probability readings suggest the Fed won't do anything this week, you have to keep nimble and expect to see a significant move one way or the other," says JJ Kinahan, chief market strategist with TD Ameritrade.
Kinahan suggests all traders monitor the Treasury market for a temperature reading on market reaction to the Fed’s decision this week and moving forward. "It’s the fastest measure of the fixed income reaction to what is happening with Fed policy," Kinahan says. This includes the 10-year Treasury note futures contract tracked on the TD Ameritrade thinkorswim® platform (figure 1).