Market Insights: Should we worry about the first Fed rate hike?

Milestone Wealth Management Ltd. - May 23, 2015
The next move of the U.S. Federal Reserve is currently the most important and closely watched potential event in the marketplace.

Should we worry about the first Fed rate hike and where are we in the current cycle?

The next move of the U.S. Federal Reserve is currently the most important and closely watched potential event in the marketplace.  And let's be honest, it should be.  The U.S. economy is the largest in the world, and the start of a tightening bias from a very accommodative stance is a very large shift, and one that affects all other global markets not to mention currencies. In fact, they have held the overnight rate to between 0-0.25% for six and a half years.  The anticipation also seem to be hitting feverish levels due to the fact that this move continues to get pushed back on the timeline, and so it is now at the top of everyone's minds for a long period of time. The underlying reasoning for this delay is complex, but low inflation and mixed economic growth numbers are allowing the doves at the Fed to get the upper hand.  We also believe, that although financial stability is not part of their dual mandate of inflation and unemployment, they don't want to raise the rate too early (earlier than market participants expect) as it could cause a large unintended stock market correction.  

At this point in time, there is almost certainty in the current marketplace that they will not be raising rates in June (based on current Fed Funds Futures).  That leaves four more Fed meetings for the rest of 2015.  Only two of these meetings have press conferences attached to them, and it would seem to be a pretty solid suggestion that they will not make their first rate hike without a press conference.  These two meetings are in September and December.  History has showed that the Fed is hesitant to raise in December due to lack of liquidity in the markets, so really we are looking at September as the one and perhaps only time the Fed hikes the rate this year.  At present, we are on the fence on whether they do raise in September and perhaps leaning towards no.  We think it will fully depend if year-over-year core CPI stops going down and reverses course. The Fed Funds Futures are currently pricing in a 27% implied probability of a rate hike in September, but that moves up to 62% for December. Therefore, the market believes we are likely in store for one hike this year, but not likely until December which would negate our lack of liquidity view against it.  However, if we are correct then there is a decent chance we don't get a hike until 2016.  

With that framework in place, what does this shift in monetary policy mean for the U.S., and by extension, the Canadian markets?  For the most part, we believe that this tightening bias is mostly priced into the equity markets, but any slight surprise could disrupt them and cause increased volatility.  Using the past as a guide can definitely help shed light on the current situation and how it will affect the current positive cycle we are in.  

The current economic expansion is the sixth longest in U.S. history and much longer than average.  However, there is good reason for that and likely good reason for it to continue as well.  After such a massive collapse in 2008/9, the current slow growth, low inflation and low interest rate environment is very much conducive to a long expansion and a good environment for equity market returns.

Post-war history has shown that the Fed has typically started to raise rates when GDP and equity markets are about one third of the way through their cycle.  This is a positive.  S&P500 historical peaks are on average 40 months after a first rate hike and a year after the last hike.  Another positive!  In addition, there is still an output gap of 2% in the U.S. which usually would have been closed by now, pointing to plenty of room for additional growth in product and labour markets.  That's one more in the plus column.  In fact, from our research it seems as though the only event or process that has ended a positive cycle in the U.S. is the end of tightening, a liquidity crisis and a flat to inverted yield curve.  At this point we seem to be a long distance away from that, and thus on balance we remain positive.