The Federal Reserve is in a policy jam. The rates-setting bank of banks is stuck between signs of improving U.S. economic fundamentals and the uncertainty sparked by a global stock sell-off. Investors are caught up in rates uncertainty, too, as no clear message came down from the mountain last weekend.
The Fed’s annual symposium in Jackson Hole, Wyoming—known to be a newsmaker in the past—failed to shed light on the fate of interest rates at the September 16–17 policy meeting. As recently as a few weeks ago, the September meeting was considered by many to be a lock for delivering the first change to interest rates in nine years.
Even as the stock market gyrated, rates expectations priced into Fed funds futures markets shifted. Friday’s pricing put the probability of a rate rise in September at 34%. Those odds were up from 25% last Wednesday.
The Fed funds rate has been stuck at zero to 0.25% since December 2008, a historic low for a record number of years. The last time the Fed actually raised interest rates was in June 2006. The Fed wants to begin normalizing monetary policy, but below-target inflation plus concerns about the recent financial market instability are now potential roadblocks to that plan.
Last Wednesday, New York Fed President William Dudley seemed to close the door on a September rate hike, saying it looked “less compelling” based on market turmoil. But at the end of the week, Fed Vice Chairman Stanley Fischer suggested that markets might calm down quickly, setting up a rate decision largely independent of short-term market swings.
"Our feeling is there is a strong likelihood they will raise rates in September," says Sam Stovall, chief equity strategist at S&P Capital IQ. However, "there is a lot of uncertainty as it relates to the Fed, and investors are trying to evaluate if the slowdown in Chinese economic growth will impact our economy, our growth prospects, and our earnings increases.”
Last week, Barclays moved its rate lift-off call to March from September, pointing to the recent sharp spike in financial stress and volatility. "Although we continue to see economic activity in the U.S. as solid and justifying modest rate hikes, we believe the Federal Reserve is unlikely to begin a hiking cycle in this environment for fear that such a move may destabilize markets," Barclays analysts wrote in a research note.
"Is the worst behind us? Possibly not," warns Stovall. Month-to-date through August 28, the S&P 500 (SPX) dropped 5.5%. In the 11 times that the SPX has fallen by more than 5% in August, it declined in 80% of the subsequent Septembers, and fell an average of nearly 4%, S&P data shows.
Trade What You Can See
This uncertainty is one of the reasons that "we’ll likely see intraday volatility stay high,” says Kinahan. "Trading off of Fed speculation is a difficult game.”
Instead, he suggests, "trade what you know and what is there. Consider the economic data before you trade. We have potentially important numbers out every single day this week.” See figure 1 for help in tracking economic reports.
Even heading into the September 16–17 Fed meeting, "you don't have to have an opinion one way or the other. You can cut your risk ahead of the meeting and then adjust again, after the meeting, based on what they say," Kinahan says.