Where Do We Go from Here: Raise Rates or Not?
Federal Reserve Policy in recent years appeared relatively straightforward. As the FOMC were in the process of reversing multiple years of near zero interest rates, the path back to rate ‘normalization’ was communicated relatively clearly to the public. It came as part of the forward guidance they offered. So throughout the last few years, the number and timing of Fed Funds rate hikes was never a surprise.
However, after the latest 25 basis point Fed rate hike in December the path forward is not as clear.
In fact, in Fed Chairman Powell’s latest speech, in which he touched upon a robust U.S. economy that faces various uncertainties going forward, he did not make any explicit references to future rate increases. Several other Fed officials have expressed caution as well. Instead, going forward, Fed policy would be characterized by a “patient” (the new keyword) approach.
This begs the question: “Where do we go from here?”
That is, what are the possible Fed interest rate scenarios in 2019?
What would cause further rate hikes?
And what would be the effects be on stock markets?
Scenario (1): No More Rate Increases
Given the uncertainty of both the U.S. and the global economic outlook, Zacks Economists agree. More neutral language used at the official January 2019 Fed press conferences (words that replaced the bias towards further increases) is warranted.
Risk-on and risk-off investors may well interpret this central banker language as a sign the Fed is concerned about equity market volatility. The FOMC will step off the gas pedal to goose stock prices. That is, the FOMC bar for higher rates is set much higher than before.
If financial markets were to see a year without any Fed rate increases, we expect it to be driven by a slower global economy, with major market selloffs in Europe and Asia spilling over to the U.S. stocks and then into the U.S. economy. This would cause a slowdown in U.S. macro momentum.
What could prompt this snarly scenario? Perhaps it’s an unfavorable trade agreement with China, along with a synchronized weakening of global economies. That double whammy would be a data dependent cause for no Fed rate hikes in 2019. It would reduce demand for American exports and fuel fears about making deeper long-term corporate investments.
What would be the knock-on effects to equity markets? While no rate hikes would appear as a positive sign initially, we see the potential for market participants ultimately interpreting this as a flashing warning sign. The U.S. economy is not on strong enough footing to handle interest rates close to 3%. A conclusive risk market outcome from a ‘no rate hike’ scenario would then depend strongly on the wording coming out of Powell’s press conferences.
Scenario (2): Two More Rate Increases in 2019
If U.S. trade talks with China come to a successful conclusion, this can revive the slowing Chinese economy. If such a deal success arrives at the same time as a successful agreement in European Brexit negotiations, we could also see strengthening demand from that key region. The two global successes might provide a meaningful added boost to the U.S. economy.
Imagine these red roses come to a continued tight internal U.S. job market, one that draws more and more individuals formerly sidelined back into the work force. This will create further U.S. consumer and business optimism -- with increased spending on both sides. Under this rosy Valentine’s scenario, the U.S. economy gets to growth rates near 3%. Therefore, it will face a risk of overheating, in the form of rising consumer and producer price inflation.
This is clearly the most optimistic demand scenario. This is the only environment we see in which 2 more rate hikes will be justified.
Scenario (3): 1 More Rate Increase in 2019
The last scenario will be (in our view) the most likely outcome and a mixture of the first two scenarios. Ambiguous signs point towards a weakening and strengthening U.S. economy. That will require a cautiously timed rate increase towards the 2nd half of the year.
In our view, this will be interpreted by stock markets as an optimistic sign. It’s the ‘best of both worlds’ scenario. A sign that the U.S. economy can handle slightly higher rates and an interest rate environment that is neither expansionary nor contractionary. This will help the U.S. economy to maintain a healthy growth path between 2.5% and 3% across 2019.