There are two key points to understand about yesterday's Federal Reserve decision to boost interest rates another 0.25%:
- The decision to raise rates was made primarily in response to positive economic news
- The markets' reaction was less about this hike than it was the revelation that the Fed anticipates more future hikes than it had previously communicated
The first point is important to understand in terms of the response of the stock market. Stocks fell yesterday after the announcement, but today are trading higher again. That's because the same factors that caused the Fed to raise rates are also good for business and corporate profits. This is partly the "Trump effect" everyone has been discussing — the general anticipation that governement policy is about to take a sharp turn toward being more business-friendly. And it's also a result of seemingly sunnier-by-the-day economic news being reported, both here and abroad, indicating that the world economy may finally be gaining a little traction.
Digging a little deeper, experienced investors may raise an eyebrow at the idea that rising rates can be a positive (or at least, not negative) factor for stocks. Historically, it's been true that rising interest rates often choke off bull markets. I'm on the record regarding the idea that tightening monetary conditions, of which rising interest rates are a big part, is what will eventually end the current bull market. But multiple analysts/economists have pointed out that historically, rising interest rates have only been negative for stock prices at higher absolute yield levels. For example, this analysis indicates that when the 10-year Treasury bond yield is less than 5%, stock prices and bond yields have tended to move in the same direction. In other words, one would expect stock prices to rise along with bond yields from today's low levels of interest rates. It's only when yields rise above 5% that stock prices and bond yields have tended to move in opposite directions, with rate hikes hurting stocks at that point.
I wouldn't put a lot of faith in the 5% level itself — I think we could run into trouble long before we hit that historical tipping point, given how low rates are starting and how fragile the economic recovery is/has been. But the general analysis is sound: when interest rates are low, early rate hikes typically signal a return to healthy growth, which is a net positive for stocks. Eventually that dynamic shifts though, and additional interest rate hikes become negative for stocks. Thus the old market sayings like "Three steps and a stumble" referring to the historical tendency for stocks to be okay during the first couple rate hikes of a cycle, but eventually repeated hikes cause stocks to fall. (For those of you scoring at home, we've now had two rate hikes, or "steps." Just saying.)
Given that tendency for stocks to move higher with interest rate increases at today's low levels, why did markets respond poorly to yesterday's rate hike? That brings us to point #2 from the beginning of the article — it wasn't the hike itself, which had been widely anticipated for weeks, but rather the forward guidance that the Fed issued. Prior to yesterday's announcement, the Fed's public expectation had been for two additional rate hikes in 2017. Yesterday, they changed that to an expectation of three additional hikes next year.
It needs to be pointed out that these future expectations are flimsy, at best. A year ago, when the Fed hiked for the first time, their stated expectation was for four addtional rate hikes in 2016. Obviously, that didn't occur and we barely got one (yesterday's). So while the absolute number of hikes will be dictated by conditions as 2017 unfolds, what yesterday's announcement signals to the market is that the Fed is factoring in the same economic data and "Trump enthusiasm" that have been driving stocks higher. And if the Fed believes these factors are real and is preparing to act based on them, that signals stocks may have less stimulus for a shorter period of time (i.e., rates won't be as low for as long). And the eventual tipping point where higher interest rates start to cut into economic growth and stock returns will be arriving sooner than was previously expected, even if no one knows exactly where that point is.
These rising interest rates have many implications. Some of the more obvious ones are that borrowing costs are heading higher, whether that's credit card debt, auto loans, existing adjustable-rate mortgages, or new mortgages. On the flip side of that more obvious coin, savers may soon start earning a little interest again. It's incredible that we've got a whole generation who have come of age in an environment where simple savings earned nothing. (I've forced my kids to save since they were little, but my soon-to-be college age oldest has never had a "normal" bank savings account because they haven't earned anything for so long.) A decade ago, high-yield savings accounts paid 4.50% interest. We're still a long way off from those levels, but over the next year we can expect to see some of the savings accounts that have been stuck on 0.01% (seriously) start to tick higher.
On a more general basis, we should expect financial markets to become more volatile as the "fire hose of liquidity" gets turned down. Economists can quibble over whether the recent interest rate decisions represent "tapping the brakes" vs. "easing up on the accelerator." But what's unquestionably the case is that the worldwide concerted effort to pump as much liquidity into the world's economy has peaked and is retreating. That much has been obvious in the U.S. for some time, but it's happening elsewhere too. Japan recently backed away from its negative interest rate experiment, and the ECB last week announced that it would begin tapering its bond purchases starting next April. Markets optimistically took that as a net positive — the ECB extended its bond-buying program! But this is an unequivocal sign that monetary policy is tightening. Again, the reasons are good — the economic patient is getting off the sickbed and no longer requires as drastic a level of support. But those who remember the "taper tantrum" surge in bond yields when the U.S. started the exact same process in 2013 will recognize the potential for increased volatility.
When there's a huge layer of monetary stimulus sloshing around in the financial system, unexpected shocks are more muted. Take away that cushion (even gradually) and volatility is going to increase. After 10 years of central bank anesthesia, it may be a bit painful getting reaccustomed to what life without pain-killers is like.
Wrapping up with a note on gold, given its particular interest among DAA investors, yesterday's news would sure seem to be the final nail in the coffin. Not only are higher rates bad for gold (yields on competing safe-haven investments go up, while the overall need for safe-havens decreases in the face of better economic growth), but the relative position of U.S. interest rates compared with yields around the world virtually ensures that the dollar is going to stay strong (or get even stronger). With gold priced in dollars, a strong dollar puts additional pressure on gold's price. It seems likely we'll be replacing it at month-end in DAA. It's not a simple decision whether to sell it now or wait until month-end for the formal signal: given the sharp declines it has experienced, it could be due for a bounce. Either way, it would seem DAA investors will likely be moving on from gold before long.