The Fed hiked rates for the third time in 2018 and removed language from its statement in which it had vowed to keep policy, “accommodative.”
The Fed’s 25-basis point came as the markets had expected, and was the third this year
The Fed removed language from its statement in which it had vowed “accommodative” policy
Markets jumped after the Fed decision, with the Dow Jones Industrial Average ($DJI) up 100 points
(Wednesday Post-Fed Meeting) Wednesday’s Fed rate hike probably didn’t surprise many investors. What did stand out was the Fed removing a single word, “accommodative,” from its press release. This is a pretty remarkable change from the past decade in which the central bank emphasized its efforts to stimulate a sluggish economy.
With Wednesday’s move, the target range for the federal funds rate now sits between 2% and 2.25%. That’s the highest it’s been since the Great Recession a decade ago, but just barely into the 2% to 5% range where the Fed has historically kept rates.
Perhaps more importantly, the Fed’s removal of “accommodative” language could signal that after all these years, the training wheels are off and the economy can forge ahead on its own with less help from the monetary side of the equation. That stands to reason, because the economy is doing fantastic and the market probably doesn’t need the same kind of support from the central bank.
Arguably, the market liked the revised wording. Stocks, which had been higher before the decision, climbed a little more in the minutes afterward, with the Dow Jones Industrial Average ($DJI) rising more than 100 points. While an accommodative Fed has probably been one major reason for the market’s rally over the last nine years, investors seemed to feel the Fed’s new stance is a positive sign of an improved economy.
Looking more closely, here’s what changed in the statement: Last time out, the Fed said, “The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2% inflation.” That language isn’t in the new release, and it arguably stands to reason. The economy grew more than 4% in Q2, unemployment is at 3.9%, and inflation is 2% year-over-year by many measures. The Fed’s inflation target is 2%.
Wednesday’s Fed decision marked the third rate increase this year and the eighth in the current hiking cycle, which began in late 2015. In the wake of the news, there wasn’t a significant move in the Treasury note market, though yields did fall slightly as some investors said the Fed’s outlook might not be as hawkish as some had thought it might.
In its press release, the Fed once again emphasized its plan to move forward with “further gradual increases” as economic activity and wages move higher. The release was pretty short, and a possible takeaway from removal of the accommodative language is that the Fed now has more worry about the possibility of inflation than making sure there’s enough cash in the market.
After the meeting, odds of a fourth rate hike this year remained above 80%, according to CME Group futures. In addition, chances for more rate hikes in 2019 are on the climb, with about a 50% chance of another one in March followed by around a 30% chance of a June hike.
The Fed’s “dot plot” of forecasts for future rate levels didn’t change all that much this time out. A December rate hike looks pretty certain if you follow the dots, and many Fed officials seem to see rates reaching 3% in 2019 and perhaps close to 3.5% by 2020.
In a press conference after the decision, Fed Chairman Jerome Powell said the economy is in much better shape now than it was a decade ago.
"In particular, we’re holding the largest banks to much higher standards in the amount of capital and liquidity they hold and in the ways they assess and manage the risks they take,” Powell said, according to Marketwatch. “I’m confident that the system today is stronger and in a far better position to support the financial needs of households and businesses through good times and bad."
What’s driving the higher rates appears to be continued strong economic growth and some creeping signs of inflation. Hourly wages rose 2.9% in August, the biggest gain since the recession ended in 2009. The unemployment rate of 3.9% is the lowest in nearly two decades. Gross domestic product (GDP) grew 4.2% in Q2.
Amid all this, inflation has moved above the Fed’s long-time 2% target. An inflation gauge closely watched by the Fed—Personal Consumption Expenditure (PCE) prices—rose 2.3% year-over-year in August, the highest since 2012. Though that number includes fickle energy and food costs, even the core PCE that strips those out rose 2%.
By steadily raising rates this year and conceivably continuing to in 2019, it looks like the Fed is trying to stay ahead of the inflation game, clamping prices before they start to spiral out of control. Few if any are predicting that kind of scenario, but the Fed remains wary of moving too slowly. At the same time, it seems like the Fed is OK with inflation of a bit above its long-term 2% goal as long as it helps the economy. There’s probably no one at the Fed who wants to snuff out the budding economic rally before it goes into full bloom.
How long we can have economic growth of 4% with inflation of 2%—arguably a real sweet spot—is an interesting question to consider. Traditionally, this sort of “Goldilocks” scenario seldom lasts long. Either prices start moving higher as workers demand more pay in a tightening job market (and that seems like it’s starting to happen, judging from a few strikes cropping up around the country), or growth starts to fizzle due in part to higher interest rates that swallow demand. How the current scenario might ultimately play out remains a question only time can answer.
The debate moving ahead is what this hike and the possibility of even higher borrowing costs might mean for the market. In one sense, investors have grown used to watching the Fed regularly step in to tighten, and the stock market has reached record highs anyway. Traditionally, however, stocks haven’t typically done as well in times of higher rates and climbing yields on Treasury notes that often accompany them.
For companies in the consumer discretionary and tech sector, rising borrowing costs could start to be a natural brake on demand. Just last weekend, The Wall Street Journal had an article noting a trend in which many car buyers are gravitating toward cheaper used models rather than buying new. It’s unclear how big a role higher interest rates on car loans might play in this scenario, but some influence is hard to rule out.
The housing market has had its share of struggles, in part due to rising mortgage rates. Housing demand often slows when rates climb, though it’s worth noting that rates were higher than now in the mid-2000’s during the real estate market’s historic rally to record home prices. Home builders and some of the major home improvement companies like Home Depot (HD) and Lowe’s (LOW) can sometimes be good barometers of how the housing market is doing, so consider keeping an eye on those names in the weeks ahead. Mortgage rates are up 75 basis points from a year ago.
At the same time, higher rates tend to weigh on shares of traditional “dividend” companies like consumer staples, utilities, and telecoms.
Figure 1: Stocks Pop: After the Fed’s rate hike, the S&P 500 (SPX) moved initially higher before giving back some ground, while yields on 10-year Treasury notes (purple line) declined. Data Sources: S&P Dow Jones Indices, CME Group. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Bullet Count: Just three years ago, the Fed had no way it could lower rates—they were essentially at zero, and had been since late 2008. That’s in part why the Fed and other central banks around the world had started the “quantitative easing,” or “QE” process, in which they purchased government securities to push down borrowing costs. There was simply no other way to make the borrowing environment easier and get companies and consumers to go out and spend.
At this point, the Fed has raised rates eight times since late 2015 and they’re back over 2%. The question is whether this gives enough ammunition for the Fed to ease rates in a possible recession or other economic emergency. Back before the last recession, which began in late 2007, the Fed Funds rate had risen above 5%. Before the previous recession, it had been above 6%. The more bullets in the gun, the longer the “runway” the Fed has to try its hand at jump-starting a sagging economy. However, at the current rate of 2% to 2.25%, the Fed doesn’t have as many bullets as in the past, so that could be one reason many analysts expect additional rate hikes from here.
Growing Comfortable? When the 10-year Treasury yield popped above 3% earlier in the year, some investors were concerned that inflation might soon be rearing its ugly head. But when the longer-dated yields dipped even as the Fed continued to hike rates at a measured pace, there was concern that a potentially flattening yield curve could foreshadow a recession. When the 10-year rose back above 3% last week, the market seemed to take it in stride. Looking ahead to a year from now, the futures markets have priced in an 80% chance of another hike in December, and a 50% chance of at least two more in 2019. If that were to come to fruition, it would put the Fed funds rate at or near 3%. In other words, the market seems to be growing comfortable with either a flatter (or inverted) yield curve, or an even higher yield on the 10-year Treasury.
The Fed, Earnings and the Stock Market: The Fed’s dual mandate is full unemployment and monetary stability, not a rising stock market. However, the Fed tends to watch the same fundamentals that drive Wall Street. This is important to note as the fall earnings season kicks off. Often, Q3 results set the tone for the full year, because investors get Q3 results and Q4 guidance. In some years, this “full-year snapshot” dynamic can mean higher volatility. When you consider the futures market is pricing in a heavy chance of another hike in December, you might have a pretty good idea of how the year is going to shake out. The question is how that might shape Fed policy going into 2019.
The TD Ameritrade Network is brought to you by TD Ameritrade Media Productions Company. TD Ameritrade Media Productions Company and TD Ameritrade, Inc. are separate but affiliated subsidiaries of TD Ameritrade Holding Corporation.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
TD Ameritrade and all third parties mentioned are separate and unaffiliated companies, and are not responsible for each other’s policies or services.
Inclusion of specific security names in this commentary does not constitute a recommendation from TD Ameritrade to buy, sell, or hold.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2018 TD Ameritrade.