Less Hawkish Tone: Rates Rise Again, But 2019 Might See Fewer Hikes

(Wednesday Post-Fed) After putting the pedal to the floor on rate hikes this year, the Fed appears ready to ease off a bit in 2019.

As the Fed raised rates Wednesday for the fourth time in as many quarters, it projected only two for next year. This comes amid a murky backdrop of tariff wars, slumping and volatile stock markets, and slowing global economic growth. These appear to be among the things Fed Chair Jerome Powell referred to in his post-decision press conference when he mentioned “cross currents” that might lead to some softening. Back in September, the Fed had forecast three rate hikes in the year ahead.

Wednesday’s rate hike, which received a unanimous vote and puts the Fed funds range between 2.25% and 2.5%, was widely expected and shouldn’t be much of a surprise to investors. It pushed rates to their highest level since before the last recession in 2008 and continued a recent pattern of quarterly rate increases. However, even as the Fed tightened the money supply again, it sent a somewhat dovish message by changing the tone of its accompanying statement. This could reflect the Fed trying to “thread the needle” by delivering soothing words even as it tightens.

Last time out, in November, the Fed’s statement said unemployment had “declined.” This time, it changed that to “remained low.” Last time, the Fed had said it expected “further gradual rate increases.” Now, it says, “some further gradual rate increases.”

It maintained previous language about risks to the economic outlook remaining “roughly balanced,” but now has some new language in the same sentence noting that it”will continue to monitor global economic and financial developments and assess their implications for the economic outlook.” That sounds like it’s building on what Fed speakers have said recently about letting data be more of a driver going forward.

Stocks Get Slammed To New 2018 Lows After Announcement

Stocks fell to new lows for the year soon after the decision, retreating from strong early gains. By an hour after the announcement, the S&P 500 Index (SPX) was down to just below 2500, compared with its 2940 intraday high for 2018 less than three months ago (see chart). Maybe once the market digests all of this, it might take away a positive message from the Fed deciding to hike rates at all considering how much pressure hit Wall Street lately. If the Fed hadn’t moved forward, it might have sent a negative signal that perhaps things are a lot worse than people had thought. 

As it is, this rate hike arguably tells investors that the Fed continues to see strong U.S. growth (it mentioned that in the statement). Basically nothing changed in the Fed’s assessment of the current U.S. economy from the statement it delivered last month. Job gains and household spending have been strong, the Fed said, and economic activity “has been rising at a strong rate.” Core inflation remains near 2%, the Fed’s long-term target.

Powell Cites “Cross-Currents” Affecting Fed View

As his press conference continued, Powell expanded a bit on his “cross currents” comment. He noted that the Fed sees growth “moderating ahead” from a rising trajectory in 2018. There’s been a “tightening of financial conditions” over the last months, he added, and “weaker growth abroad.” Those are factors that helped shape the Fed’s decision to slightly lower its growth and inflation predictions for 2019.

Powell still sees U.S. unemployment staying historically low, falling to 3.5% by the end of next year from 3.7% now. Over the next year, he said, “judgments of people will differ” as to whether the Fed’s policy is “mildly accommodative, neutral, or mildly restrictive.” He noted there’s an “array of diverse views” at the Fed, and that current economic conditions allow the Fed to be patient in making its rate decisions.

Inflation “continues to surprise to the downside,” he added. The Fed isn’t trying for inflation of under 2%, but “symetrically” around that figure. “We have not declared victory on that,” Powell said.

He said the Fed will continue to reduce its balance sheet at the current pace, and that seemed to weigh on the stock market a bit. Maybe some investors had hoped the Fed might ease off on that reduction, which can sometimes have an upward impact on rates.

Big U-Turn for Stocks After Fed Announcement

Despite the subdued tone of the statement and the easing off of 2019 hike expectations, the stock market fell into negative territory right after the decision. Maybe some investors had hoped for an even more dovish outlook on 2019, because two rate hikes is still more than many economists had predicted. In fact, some analysts wondered if there would be any hikes at all next year, given the economic headwinds overseas and signs of interest rates putting a brake on the housing market here.

The Federal Open Market Committee (FOMC) also lowered its outlook for the long-run funds rate, from 3% in the September forecast to 2.8% this month. The 2019 estimate declined to 2.9% from 3.1%, and both 2020 and 2021 dropped to 3.1% from 3.4%. 

That said, not all of the FOMC members seem so dovish. Six of 16 still expect three rate hikes next year, according to the updated “dot plot” issued Wednesday. That’s down from nine who did in the last dot plot, but not an insignificant number.

Maybe some of the weakness in stocks following the decision had to do with the Fed’s reduced economic outlook. It now sees 3% U.S. gross domestic product (GDP) growth this year, down from 3.1% previously. It expects 2.3% GDP growth next year, down from the previous 2.5%.

On the positive side, the Fed lowered its inflation outlook. It now sees 1.9% inflation in 2018, down from 2.1% previously, and 1.9% next year, down from 2%.

Walking the Tightrope

Going into today’s decision, the Fed arguably faced a tightrope walk. A lot of pressure had emerged in recent weeks, with influential names in the world of finance and economics encouraging the Fed to consider a pause amid plunging U.S. stocks and crumbling crude prices. Worries about a possible overseas slowdown dominated headlines, and the 10-year bond yield in Germany fell below 0.25%, compared with above 2.8% for the U.S. 10-year yield.

At the same time, the U.S. yield curve, or the gap between short-term and long-term yields, continued to narrow, falling to as low as 13 basis points between the two- and 10-year Treasury yields late last week. An inverted curve—in which the longer-term yield falls below the shorter-term—can make it more difficult for banks to make money, possibly contributing to fewer loans and a slower business climate. Often in the past, yield inversions have accompanied recessions. As the Fed raised rates in recent years, the hikes seemed to push up the lower-end yields more than the higher-end ones, perhaps because investors aren’t fully convinced that long-term U.S. growth can continue to be as robust. Another hike, it seems, could cause more chance of an inverted curve.

The Fed also faced pushback from the Oval Office, where President Trump publicly made his distaste for additional rate hikes known. To sum up, it seems like it’s been a long time since the market approached a Fed meeting with so much appearing to ride on the decision and so many arguments being made against a hike. This contrasts with a few years ago, when many economists were saying the Fed had waited too long to tighten from the essentially 0% rates that lasted many years after the 2008-09 recession.

Thanksgiving Rethinking

As this whirlwind blew, the Fed seemed to reconsider its previously hawkish tone back around Thanksgiving. Both Powell and Fed Vice Chair Richard Clarida said in speeches that the Fed funds rate was approaching what they’d consider a “neutral” level that’s not too accommodating or too restrictive. That level is around 2.5% to 3.5%, historically, according to some economists, compared with the Fed funds range at the time of 2% to 2.25%. The language from Powell contrasted with what he’d said in early October about rates being “a long way” from neutral, a phrase that might have contributed to some of the stock market selling that began that month. 

Instead, Powell and Clarida both implied that the Fed might become more data driven. At the same time, neither hinted at short-term policy changes, and futures prices continued to indicate a 70% to 80% chance of a December hike. The odds of more hikes next year, however, fell pretty sharply until the market indicated just a 50-50 chance of even one 2019 hike, compared with the Fed’s September “dot plot” that indicated three for the 2019 calendar year.

Different Environment Since Last Hike

Since the last rate hike in late September, the S&P 500 (SPX) has fallen more than 10%, but other U.S. economic indicators remained mostly positive, adding to the Fed’s conundrum. The government’s latest estimate of Q3 gross domestic product (GDP) was a solid 3.5%, and Q3 earnings per share growth was very impressive at above 28%. Meanwhile, inflation stayed muted by most measures despite 3.1% hourly wage growth in both October and November. Unemployment stayed near 50-year lows of 3.7%, though the U6 unemployment rate (which includes discouraged workers no longer looking for a job and part-time workers who want but can’t find full-time work) ticked up to 7.6% in November from 7.4% in October.

This positive U.S. climate contrasted with bearish economic data from both China and Europe earlier this month. The Fed had to decide if strong U.S. growth has a chance to eventually heat up inflation, even as it worries that weakness abroad might hurt U.S. companies and slow U.S. economic growth. That’s arguably a problem that could be exacerbated if U.S. borrowing costs stay relatively high compared with the rest of the world.

Plunging crude prices might have been another factor in the Fed’s decision. A drop in demand for fuel could indicate falling consumer and business demand on a wider scale, raising more fears about economic weakness. Also, the drop in crude prices basically removed one major contributor to the U.S. inflation pie, with average gas prices falling from around $3 a gallon last spring to around $2.35 a gallon in early December. Lack of any inflation associated with energy prices could conceivably give the Fed a longer runway to keep rates low without having to worry as much about any price shocks.

At the same time, not everything was great here at home. Interest rate-sensitive sectors like housing and automobiles slumped over the last few months, something some economists attributed to higher borrowing costs. That’s another consideration the Fed had to take into account. It seems that lately, U.S. consumers have been happy to make smaller, short-term purchases, but not so enthusiastic about long-term buys that might require borrowing money. It’s likely the Fed could keep a close eye on those sectors (housing and autos), as well as business investment (which grew more slowly in recent months), as the new year starts and it watches the data come in. Any sign of more weakness associated with higher rates might help shape its decisions for the meetings ahead.

Figure 1: Stocks, Ten-year Treasury Yield Fall After Hike. Wednesday's rate hike seemed to pressure stock indices such as the S&P 500 (SPX - candlestick chart). But a seemingly dovish tone for 2019 helped send the yield on the 10-year (TNX - purple line) down to 2.78%  Data Source: S&P Dow Jones Indices, Cboe Global Markets. Chart source: S&P Dow Jones Indices. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.

Global Tables Turned: A few months can sure make a big difference in stocks, as anyone holding onto a basket of “FAANGS” in their portfolio say, last August, could probably attest. What we’re talking about here, though, is how things have changed overseas compared with the U.S. At this point, U.S. stocks have done the worst of the three biggest markets (U.S., China, Europe) since peaking in late September. During that stretch, stocks in Shanghai have fallen 9.6% as of midday Wednesday, stocks in Europe had fallen 11.6%, and the S&P 500 Index (SPX) was down 12%. The Russell 2000 (RUT) small-cap index was doing even worse, down more than 19%. 

That’s sure a contrast with earlier this year when U.S. stocks led the way. In fact, the leader now might be China, where the Shanghai Composite has actually risen 2.5% since the closing low on Oct. 18. A year ago, a lot of investors were talking about “synchronized global growth” and starting to plow money into emerging markets. That probably hasn’t worked out for many, but the recent uptick in China might be a hopeful sign. Still, until the U.S. and China hammer out some sort of trade agreement, it might be hard for emerging market stocks to find much traction. If investors aren’t sure what the rules of the game are going to be, they might be tentative about getting into the action.

What Do You Know? Doesn’t it seem like every time there’s a Fed meeting, an important number is due a day or two later that it seems the Fed might have wanted to see before making a decision? This time it’s the government’s final estimate of Q3 gross domestic product (GDP), along with Personal Consumption Expenditure (PCE) prices. Both are due Friday. The GDP number doesn’t seem too likely to change much the third time around, at least not judging from the average analyst estimate of 3.5%. That’s the same as the government’s second estimate. 

The Fed has said it closely watches PCE as an inflation indicator, and it rose 0.2% in October. Core PCE, which strips out food and energy, rose 0.1% that month. This time out, analysts look for a flat headline reading in November, probably in part due to falling gas prices. For the core, analysts still expect a muted 0.2% rise, according to Briefing.com. If the numbers end up looking this vanilla, maybe the Fed wouldn’t have needed to see them ahead of time after all, come to think of it.

About That “Earnings Recession…” Going into today’s Fed decision, it’s possible a lot of the recent weakness in stocks might have hinged on investor ideas that earnings growth in 2019 might not be up to par. There’s even been new talk about an “earnings recession,” like the one in late 2015 that dragged the market then. Still, most analysts see 2019 earnings growth in the mid-single digits, and no sign of earnings falling. Estimates are down from a few months ago, perhaps reflecting slowing overseas economies and even chances of some slowing growth in the U.S. 

Earlier this week, research firm CFRA called earnings recession talk “premature.” It forecasts S&P 500 earnings per share growth slowing from its Q3 2018 peak of 28.6% to 5.2% by Q3 2019, before recovering to a better than 12% pace through Q3 2020. History shows that the stock market can be pretty good at predicting potential EPS recessions, CFRA said. The S&P 500 Index (SPX) started a decline in excess of 10% a median of four months ahead of the start of an EPS recession and was correct nearly 60% of the time. There have been 15 EPS recessions (defined as EPS falling for two consecutive quarters) since World War II.