The Keyword is Patience
Fed Chairwoman Janet Yellen is proving to be a skilled financial tightrope walker. Like a crouched tiger ready to pounce, the market has been waiting on the removal of the word “patient” from the Fed’s policy statement on rate hikes, Yellen did indeed remove the word “patient” but tempered expectations, pointing out that removal of one word does not imply impatience and imminent rate hikes.
The removal of “patient” from the report was expected to trigger a drop in the market by signaling an upcoming rise in interest rates. Instead, the market responded with an across-the-board rally. The NASDAQ and Dow re-crossed their previous thresholds of 5,000 and 18,000 respectively. Bonds rallied and the yield on the 2-year note took its greatest fall since 2011, dropping below 2%.
How does she do it? Actually, a better question is, “Why does she do it?” In our view, Yellen has solid cause to maintain the current Fed stance on interest rate hikes. Instead of looking at the internal metrics of wages, employment, and inflation, she is considering the global economic situation.
Employment, Wages, or the Dollar?
As other have done, we’ve pointed to anemic wage growth in the current recovery, and persistently high numbers of underemployed and long-term unemployed workers, as primary reasons the Fed has been reluctant to raise interest rates. These excuses may be trumped by another trend — the recent strength of the dollar.
Our economy may not be going gangbusters, but it is growing — and doing so at a substantially higher rate than most of the world. A strong dollar is expected under those conditions, but the US Dollar Index (NYSE:DXY) is unusually strong — briefly topping 100 last week. Tom Lee of Fundstrat produced a chart showing that the 7-month average in the DXY has hit the highest percentage rise since 1981. It may surpass that mark next month.
The strong dollar puts the Fed in an interesting position with respect to interest rates and the effect on the economy. The dollar’s relative strength probably has more to do with monetary policy that is currently (pun intended) looser than ours, especially within Europe and Japan.
A Fed rate increase will strengthen the dollar further and likely put a squeeze on equities. Earnings and profits of many larger US companies could shrink due to a corresponding drop in exports and overseas revenue.
Certainly, there is no inflation or strong domestic growth to require hitting the brakes with a rate hike, so the Fed has chosen to continue to drag out rate hikes and normalize policy as slowly as it possibly can.
Rate Projections Adjusted Downward
The Fed’s short-term interest rate projections have also been adjusted lower to meet the more likely scenario of slow growth and little inflation. December 2015 expectations were lowered from 1.12% down to 0.625% (a rise of 0.5% over the current 0.125%), The December 2016 and 2017 estimates are at 1.875% and 3.125% respectively.
The Financial Times implies that the bond market has been a better predictor of rates in recent times, and interest rate futures suggest even slower rate hikes than the Fed projections. Those projections are 0.5% for December 2015, 1.2% for December 2016, and 1.875% for December 2017.
To put this in historical context, consider the rate of change at the beginning of past rate hike cycles. June 2004 to June 2005 saw a rate hike from 1% to 3.25%, or 2.25% total. June 1999 to June 2000 saw a change from 4.75% to 6.5%, or 1.75%. Rates from February 1994 to February 1995 went from 3% to 6%, a full 3% increase. Those are all far below the Fed’s new projections of a 0.5% rise this year and a 1.25% rise next year — overall a pretty tepid endorsement for economic growth.
The Fed has again managed to signal their future rate hike strategy in a way that has kept the market relatively stable — although there doesn’t seem to be any way to avoid a single-day overreaction, either positive or negative.
By dropping their interest rate projections, the Fed may be concluding that US growth will continue at a moderate pace throughout 2015, and that the world economy will probably fare no better.
Moreover, inflation is unlikely to rise up and sway Fed opinion. Oil prices will eventually rise and give a false sense that inflation is worse than it appears, but the Fed has already noted this and is unlikely to overreact.
Even in these odd economic times, the tried and true advice works the best: stay diversified. The Fed has made it clear that, in the absence of strong inflation-producing growth — which doesn’t appear to be anywhere on the horizon — rate hikes will be drawn out over the longest possible time horizon.
Aside from the predictable one-day overreaction, the markets are likely to stay relatively calm with a miniscule hike. Stocks are not suddenly going to look like poor investments in comparison. It is therefore, advisable to stick with your current portfolio plan and expect equities to continue upward, albeit more slowly than some would like.
In essence, the Fed dropped the word “patient” but still intends to be patient with respect to rate hikes. Focus on the actions, not the words.