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New Headwinds for Markets

Rising short-term interest rates could contribute to tougher financial conditions ahead.

The stock market can get sideswiped by major policy changes (like new tariffs), but it may also react eventually to small, incremental adjustments that it had seemed to ignore at first. The rise in short-term interest rates is one such change that is starting to impact the broader market now and that we think could contribute to more volatility ahead.

The Federal Reserve decided to raise interest rates a quarter of a percentage point last week. It’s the sixth hike since December 2015 and brought the federal funds yield to 1.5%, up from near-zero during the six-year period following the financial crisis. The two-year Treasury note now yields 2.28%, up from 1.9% at the start of this year, incorporating the Fed’s suggestion that it may well hike three times in 2018.

Rising short-term rates didn’t lead to market turbulence in 2016 and 2017. That’s partly because the Fed did such a fine job telegraphing its intentions and also because the economy was enjoying a period of synchronized global recovery.

However, I sense that the benign relationship between Fed policy and financial conditions may be shifting and rising rates may start to bite.

The metrics that lead me to this conclusion are quite sophisticated. I’m looking at things like bank system liquidity, credit spreads and the rising costs of currency hedging. Of particular interest: The gap between Libor (the rate banks charge to lend to each other overnight), and the fed funds rate has widened recently to a level last seen during the financial crisis. A surge in short-term Treasury supply due to deficit-financed tax cuts and the Fed shrinking its bond holdings may also be contributing to higher rates.

This all bears watching. In addition to rising short-term rates, we think credit spreads could widen and the dollar strengthen more, leading to higher cost of capital (and lower profits) for companies. Investing in portfolios designed to hold up whether broader markets rise or fall could make sense.

While these are normal events at this late stage of the business cycle, they are headwinds for markets. I will be keeping close watch on measures of financial conditions.

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MORGAN STANLEY ACCESS INVESTING