Investors need to remember that the Fed is not the Monster under the bed
One day, the Federal Reserve’s recent run of rate hikes will end – or will continue – and that provokes a lot of investor anxiety. Fortunately, those fears are overblown.
Here is the thing about the Fed: rate hikes and rate cuts are almost always gradual and predictable, as the Fed itself has committed to do in writing. But the market is afraid nonetheless.
The concern that interest rates could rise a lot stems from past Fed moves. The market remembers 2004 when the fed funds rate soared from 1% to 5.25%. And 10 years before that, in 1994, it climbed from 3% to 6%. And before that, in 1987, from 5.87% to 9.75%. This suggests that the Fed does not fool around when it changes policy.
Accordingly, the market seems to think that once the Fed sets out to change course it will do so with a damn-the-torpedoes approach, ignoring all sorts of dislocations in the prices of securities and bringing the economy to a grinding halt.
This is evident by the market reaction to news. Anything that pushes forward the starting date, like soft data or a dovish statement from a Fed official, sends the market up. Strong data or hawkish comments, however slight, send the market down. The media’s obsessive focus on Fed policy makes this worse.
Investors should relax. The Fed is a long way off from changing course in any meaningful way.
Traders Don’t Believe the Fed
On Wednesday, June 19, 2019, the Fed held the line on interest rates and formally suggested that no cuts are coming in 2019. The central bank suggested that one or two cuts might happen, but not until 2020.
But guess what? Market traders are still betting on Fed cuts as soon as the end of July due to Fed Chair Powell’s press conference where he said, “many participants now see the case for somewhat more accommodative policy has strengthened.”
In fact, according to the CME FedWatch tool, the fed funds futures market is now pointing to a 100% chance of an easing of monetary policy next month. In fact, traders placing real bets on the CME exchange are saying that there is a 64% chance of one rate cut and a 36% probability of two cuts.
Funnily enough, do a quick Google search and you’ll find headlines that scream inflammatory titles like “Divided Federal Reserve holds the line on interest rates” from CNBC and “A Split Fed Decision” from the Wall Street Journal.
But the Federal Open Market Committee voted 9-1 to keep the benchmark rate in a target range of 2.25% to 2.5% - hardly a split decision (St. Louis Fed President James Bullard voted to cut rates).
The Fed’s Actual Release
Here is what the Fed actually said in its release:
“Information received since the Federal Open Market Committee met in May indicates that the labor market remains strong and that economic activity is rising at a moderate rate. Job gains have been solid, on average, in recent months, and the unemployment rate has remained low. Although growth of household spending appears to have picked up from earlier in the year, indicators of business fixed investment have been soft. On a 12-month basis, overall inflation and inflation for items other than food and energy are running below 2 percent. Market-based measures of inflation compensation have declined; survey-based measures of longer-term inflation expectations are little changed.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. In support of these goals, the Committee decided to maintain the target range for the federal funds rate at 2-1/4 to 2-1/2 percent. The Committee continues to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective as the most likely outcomes, but uncertainties about this outlook have increased. In light of these uncertainties and muted inflation pressures, the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective.
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”
The Fed is No Monster
A change in Fed policy is a monster under the bed keeping investors awake at night: scary, but not real. No doubt, there are always reasons to worry. But investors who think their main threat today is U.S. monetary policy are looking in the wrong place.