Over the last few weeks we have seen the return of market volatility on concerns about the strength of the US economy and the potential timing of the Federal Reserve's next rate hike. Market fears spiked last week when key Fed officials suggested that markets have it wrong, and are "under-estimating" the likelihood of rate hikes in the nearer term. As noted in April's Fed Open Market Committee (FOMC) minutes, most Fed officials seem surprisingly optimistic about another interest rate hike as soon as June. From the report: “most participants judged that if incoming data were consistent with economic growth picking up in the second quarter" then the Fed may opt for a hike next month. The report also said that if "labor market conditions" continue "to strengthen" and inflation makes "progress toward the 2% objective", then it might "be appropriate for" the Fed "to increase the target range for the federal funds rate in June."
What does that mean?
At face value, the Fed is signaling that interest rates might increase sooner than the market currently expects, and that they might also go higher than expected. The market does not like surprises, and this one resulted in renewed volatility, particularly in equity markets over the last few days.
"...the Fed is signaling that interest rates might increase sooner than the market currently expects..."
First: This Is Nothing New
For the last two years, US stocks have been largely range-bound, with occasional sharp moves both up and down in a sideways, see-saw trading pattern. We called 2015, for example, a “thrill-ride to nowhere,” and thus far 2016 has been much the same. This trading pattern is not atypical during a period of gradual rate tightening, and when investors are unclear about economic prospects in the immediate term. While impossible to predict or time, markets tend to get more volatile just before and just after rate hikes, and in this regard, the recent market action is quite normal and no reason for alarm. It is consistent with the trading environment we’ve seen over the last 18 to 24 months.
Fed Likely To Remain Cautious
Raising rates has the consequence of slowing economic growth by increasing borrowing costs and pulling liquidity from the financial system. The Fed is mindful that it has to be ready to do just this, to combat inflation, when necessary. At the same time, however, they must keep monetary policy loose enough to ensure the economy doesn’t stall.
"...a gradual rise in interest rates, if done thoughtfully, and if based on economic data, can be positive..."
The recent Fed minutes mention that inflation is now getting close to its target 2%. Does this mean that faster and steeper rate hikes are inevitable? Probably not. It’s true that readings on inflation have risen of late, with core Consumer Prices (excluding volatile food and energy costs) touching and then briefly exceeding the Fed's 2 percent objective. In our opinion, recent spikes in Consumer Prices are transitory and that the Fed still has time to be patient, and no need to aggressively hike rates.
As Rates Do Go Up -- It's A Good Thing
One of the reasons interest rates are so low is a holdover from the Great Recession and the extraordinary means US and global central bankers employed to kick-start economic growth and stave off what could have been a depression. The fact that the Fed has begun the slow path to normalize monetary policy with their first (modest) rate hike last December is actually a good thing. It means policymakers see signs of sustainable strength in the economy. Greater economic growth is good for employment, wage growth, savings rates and consumer spending, and all of this tends to be constructive for stocks over longer periods.
Furthermore, higher interest rates enable investors, particularly retirees, to generate higher levels of income from their savings. Bottomline: a gradual rise in interest rates, if done thoughtfully, and if based on economic data, can be positive for both aggressive and conservative investors over the long term.