• Wealth Management

Optimism Over Fed Policy May Not Last

Despite a softer tone, the Federal Reserve may hike rates several more times in the next year.

Markets rallied last Wednesday when Federal  Reserve Chair Jerome Powell made comments that some investors interpreted as signaling that the Fed won’t raise interest rates as many times next year as expected.

The S&P 500 surged more than 2%, returning to positive territory for the year to date. It had slipped into the red in October, and again in November, during sharp, but relatively brief selloffs.

While Powell’s more moderate stance may be a plus for markets, I think investors need to keep it in perspective. Below are three reasons the shift in commentary isn’t a game changer:

  • Morgan Stanley Research’s analysts never thought the Fed would hike three times next year. That’s what previous Fed guidance had indicated, but our official Research department call is for one hike in December and two more in 2019. The firm’s view hasn’t changed. Powell’s comments may have signaled that a pause could be coming, but they were actually more nuanced than the market’s bullish interpretation.
  • The Fed is no longer the only driver of markets. Other factors may be more influential lately. Tilting negative are interrelated factors, such as slowing global growth, trade tensions and geopolitics. Meanwhile, tax cuts and fiscal stimulus have counteracted those influences.
  • It’s not the official fed rate that investors seem most worried about. While the Fed controls the very short-term fed funds rate, investors are focused on the 10-year Treasury rate. That benchmark bond rate has risen, not just because of higher inflation, but also because U.S. economic growth has normalized—i.e., its strength and stability don’t depend on Fed stimulus. The 10-year Treasury rate, however, does reflect higher corporate borrowing costs and tighter financial conditions. And stock analysts also use it to calculate the current value of a stock by discounting future profits against the rate of return for this low-risk bond. As a result, when that rate rises, stocks often fall.

Even though stocks typically benefit from a dovish Fed, investors should remain cautious. Rather than focusing solely on Fed policy, investors need to watch issues like trade, fiscal policy, deficits and oil prices to understand where the market may head next.