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The Fed has laid the groundwork for a third rate rise in December, and more rate hikes will follow in 2018. So, investors wonder, "How will a chain of policy rate increases affect the key financial markets?"

Conventional wisdom suggests a negative correlation between policy rate hikes and equity markets. That is, stock prices trend downward in the face of tightening of credit conditions. Applying higher discount rates could cause a dent in assessing company earnings valuations too. But historically, the stock market & policy rates relationship is not as straightforward as it is in fixed income markets, where a clean inverse relationship plays out. For Foreign Exchange (FX) markets, increasing Fed policy rates have the potential to strengthen the U.S. Dollar. This supplies added earnings pressure to those companies with international sales exposure.

To answer this question better, we first need to acknowledge: Rising interest rates can be both a symptom and a cause of current market developments (it’s another one of the long lines of chicken vs. the egg questions!).

On the one hand, less heterodox Fed accommodation and more Fed rate increases can be initially examined under ceteris paribus conditions. That is Latin for "holding everything else constant" (a very rare condition that typically only occurs in Economist daydreams). Indeed, then, that would curb any ongoing reflation in equity prices via more restricted financial market liquidity. As multiple earnings headwinds, capital-intensive sectors like Industrials, Materials & Energy would suffer under tighter credit conditions. As a sole earnings tailwind, Financials should observe improving profit margins in their lending businesses.

On the other hand, what if rising policy rates occur as a by-product of improving macro conditions? That is, the Fed reacts to improving GDP growth, low frictional unemployment rates, and accumulating signs of accelerating inflation? This type of "reactive interest rate increase" typically will not cause stock prices to decline. An effect of improving Economic conditions dominates the reduced liquidity. We can see further appreciation in stock markets in 2018, if market participants interpret an increase in rates as a vote of confidence by the FOMC on the macro outlook.

Furthermore, the reaction to rate hikes could possibly be very subdued, if markets have already fully priced in the looming hikes. This is very likely. The FOMC has done an excellent job in the past couple months and years in communicating its plan to raise rates without upsetting markets (the taper tantrum in 2013 being the notable exception).

With the horns of this dilemma fully examined, what type of environment are we currently in? Rate hikes seen in 2017 did not give the stock markets any pause. The Fed lifted rates twice already this year. Yet, the S&P 500 is up more than +15% year to date. Instead it appears to us: bullish stock markets are dancing to the beat of a drummer and a floutist. The drummer is widespread global growth elevating multinational corporate earnings. The floutist is the outlook for a tax code overhaul from Capitol Hill.

Meanwhile, the Fed has recently pulled its most curious instrument out of the closet, worth $4.5 trillion: its swollen balance sheet. This hidden arsenal consists of either Treasuries or mortgage-backed securities. Beginning in October 2017, the FOMC started its balance sheet unwinding, by not reinvesting the proceeds of $6 billion of Treasury debt and $4 billion of mortgage-backed securities per month. It will gradually increase those to a maximum of $30 billion and $20 billion, respectively.

What’s the big deal? The Fed’s balance sheet is equivalent to about a quarter of U.S. gross domestic product. If the unwinding is not done right, this could have major repercussions. Janet Yellen insists the process will be akin to “watching paint dry.” Her expectation is obvious: any market reaction will be muted. However, an attempt by the European Central Bank (the ECB) in 2012 to reduce its balance sheet almost sent the Eurozone economy back into recession. That illustrates what could go wrong. It ended in a reversal of ECB policy and a balance sheet larger than before. Market reactions (so far) have been subdued to the Fed’s decision. But it remains to be seen. Will it be as boring as Janet Yellen indicated?

Finally, last week President Trump nominated Jerome Powell to be the next Fed chair. If he wins confirmation by the Senate, Mr. Powell will become the successor to Janet Yellen. What does that portend on future Fed policies? Powell served as a member of the Federal Reserve Board of Governors for 5 years. Across that time, he was a close policy ally of Ms. Yellen. We expect a continuation of the Fed’s cautious (aka Yellen era) tactical approach to normalize its policies to a pre-financial crisis status.

It’s a "safe pair of hands." So why make a change? Yellen is a Democrat. Powell is a Republican. Mnuchin wanted the same jerseys being worn at Treasury and the Fed.




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