Keep An Open Mind When Listening To Interest Rate Decisions

Well, it’s done now. Everyone (in financial markets) can go back to doing something useful. Failing that, they can go back to guessing when the next Fed rate rise will occur.

Early this morning, the US Federal Reserve performed its first baby step towards ‘interest rate normalisation’. That no one knows where normal is for the US economy is a moot point. The general feeling is that it’s somewhere north of where we are now.

The Fed itself seems to think so. It expects rates to rise slowly, but steadily, over the next few years. Or does it?

According to the Fed’s projections, the median expected official rate will be 1.375% by the end of 2016, rising to 3.5% in the ‘longer run’, which is some time after 2018. That means four interest rate rises in 2016!

It’s safe to say you can completely ignore these forecasts though. Who knows at what point the US economy will hit a brick wall as a result of rate rises? I’m tipping that four rate rises in the next 12 months won’t even get close to playing out.

An economy doesn’t go from zero interest rates for five years plus, to quarterly rate rises within 12 months. The only thing that would allow such a rapid increase in rates is a sharp pick-up in inflation.

But the Fed only has inflation getting back to its target of 2% by 2018. So that seems like a low risk scenario.

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What did the market think of all this?

It was pretty pleased. The Dow surged more than 200 points, or 1.3%, while the S&P500 was up 1.45%. Precious metals liked it too. Gold was up over 1%, while silver flew nearly 3%.

By the way, if you haven’t yet checked out my big play on silver, click here.

Longer term US bonds remained steady. But with the Fed now in ‘lift-off’ mode, shorter term bond yields are on the rise.

This will bear watching. If the Fed tries to hike too quickly, the ‘yield curve’ will flatten out. The yield curve plots the path of short term rates out to long term rates and is an important indicator of general economic health. A flat yield curve indicates weakening economic growth. An inverted yield curve (meaning short term rates are higher than long term) is a sign of imminent recession.

The curve is still pretty steep, but as I said, it’s something to keep an eye on.

So why did stocks react so positively to the Fed’s decision? After all, with the potential for four interest rate increases this year, you’d think the stock market would be nervous.

The prospect of four interest rate rises in 2016 is certainly at odds with the Fed’s mantra about a slow return to interest rate normalisation. Check out this excerpt from its statement (my emphasis):

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 objectives of maximum employment and 2 percent inflation. 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. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

It appears the market doesn’t put too much stock in the four interest rate rise forecast for 2016. That’s because the timing of future increases depends…and a forecast is just that, a forecast.

The market’s positive response was also a reflection of the Fed’s views about the health of the economy. In a Q&A session after the announcement, Yellen talked about the upside risks to US economic growth. She said consumers were in good shape, the housing market was strong and that demographics were favourable.

In other words, the US economy remains in decent health…according to the Fed anyway. That, combined with ‘data dependent’ rate rises, is pretty good news for the stock market.

What this all means for tomorrow and the next day though is anyone’s guess. Keep in mind, oil wasn’t impressed by what the Fed had to say. West Texas crude sank more than 4% overnight. That suggests deflationary pressures remain in the global economy. Fed rate hikes will only intensify these pressures.

We should take the market’s initial response to the Fed’s first rate hike since 2006 with a grain of salt. Or a block of it. It’s been a long time coming. The market was well prepared. The immediate response is probably more reflective of traders rejigging positions than anything concrete.

Let’s see how things play out over the next few weeks. Oh, and keep your eye on any sort of measure of inflation. Because the presence of inflation (or otherwise) in the US economy will be the major driver of future interest rate moves.

My wild, pointless and probably useless guess at this point is that you won’t see another rate rise for at least six months. Not with China devaluing its currency and exporting deflation to the rest of the world.

But who knows? In the modern world of central bank dominance, the best course of action is to know that you don’t know, roll with the punches, and have a flexible strategy.

Keep an open mind. You’ll need it.


Greg Canavan,

For Markets and Money

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Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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