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Can the Fed Stop the Bleeding?

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With the markets capping an already poor week with another big slide on Friday, analysts have struggled to pinpoint the exact reasons for the selloff.

Trade tensions with China are a persistent issue even after the apparently successful meeting between President Trump and Chinese President Xi in Argentina last week. The arrest in Canada of a Chinese executive who now faces extradition to the US - presumably to face charges associated with violating international sanctions against Iran - has injected new uncertainty into the situation.

Over the past few months, the fear of rising interest rates has been a concern weighing on the markets as well, though those fears have abated somewhat with rates on the 2, 5, and 10- year treasuries falling sharply the past few weeks and recent statements from Federal Reserve Chairman Jerome Powell that were interpreted to mean that there are likely to be a fewer number of increases in short term rates than was previously expected. 

Chairman Powell said in a prepared statement that, based on current data, he believes interest rates are “close to neutral.” That language was a subtle yet significant departure from his earlier statements in which he described the overnight rate as “a long way from neutral,” and which the markets had previously interpreted to mean a series of up to three more rate hikes could be expected. Some analysts had been planning for four 25 basis point increases over the next twelve months.

Prices for Fed Funds futures at the Chicago Mercantile Exchange (CME - Free Report) now predict approximately a 15% chance that the overnight rate will rise by more than 50 basis points before the last Fed meeting in December of 2019.

So that should be good news for stocks, right?

Well unfortunately, it hasn’t been lately.

Powell has attempted to be as transparent as possible, increasing the number of Q&A press conferences and making it clear that the board is focused firmly on economic data and does their best to ignore political considerations and short-term capital market impacts.

So what has that data been indicating?

Actually, it’s been mostly very benign. Few numbers lately have been materially different from expectations.

Almost every release has suggested that the US economy is growing at a steady rate, but with little chance of overheating. The most recent employment report from the Bureau of Labor Statistics came in almost exactly as expected. The headline unemployment rate was unchanged at 3.7%, slightly fewer jobs were created than analysts had predicted and average hourly earnings continue to rise modestly, up 0.2% - exactly the same as the November report and one tenth of a percent less than the consensus estimate of 0.3%.

Strong employment coupled with wages that are rising modestly ought to be a perfect environment for economic growth and strong corporate earnings.

Yet stocks continue to sell off, with all of the major averages down more than 4% last week and once again below breakeven for 2018.

Though the Fed is still expected to raise the Fed Funds target rate 25 basis points at the December meeting, it’s still unclear how the equity markets will interpret the move. Although rising rates tend to depress share prices because of increased borrowing costs for businesses and consumers, hawkish Fed action now might reassure the markets that economic activity remains healthy.

The chairmen’s language after the December meeting will be especially important. If Powell and the board see evidence of continued steady growth, it will go a long way toward calming investor’s jittery nerves and the forward P/E ratio of the S&P 500 at just 15X will start to look very attractive.

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