- During the past several years, the pace of the Federal Reserve's rate tightening campaign has evolved from glacial to more aggressive.
- Historically, the stock market has held up well amid rising interest rates, as long as corporate earnings and the health of the economy remain robust.
- Resilient financial conditions suggest that the Fed can continue on its rate tightening path without sinking the economy in the process.
- One risk to this outlook is the disconnect between the Fed's outlook for the number of rate hikes between now and the end of 2019, 7, versus the market's expectations of 2.
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
The U.S. Federal Reserve (Fed) Board's current cycle of interest rate tightening has certainly been an unusual one.
The start of this cycle began in December 2013, when the Fed first started to cut back on its massive bond buying program, a.k.a, quantitative easing (QE). The tapering continued until the Fed formally ended its QE stimulus in late October 2014. By the third quarter of 2015, the Fed was widely expected to increase rates at its September meeting. But that hike was put on hold, largely due to economic fragility in China and the massive devaluation of its currency.
The Fed finally hiked rates in December 2015, but its next hike wasn't made until a full year later. So the first part of this Fed hiking cycle was very much like pulling teeth. From 2013 through 2015, Fed policymakers repeatedly lowered their rate hike expectations to meet the market's more pessimistic outlook, according to the Fed's dot plot. (The Fed's dot plot is a graphic that illustrates individual policymaker's assessments of the appropriate federal funds rate target at the end of each of the next several years and in the longer run.)
What difference do rate hikes make?
Contrary to what many investors have come to believe in recent years, the market has normally done just fine when the Fed is in tightening mode. That's because the Fed generally tightens in response to an overheating economy, which usually implies that earnings are growing at a robust pace.
Earnings and rates both play a key role in valuing investments. When analysts attempt to value a company, they try to determine the current value of the company's future earnings. Part of that calculation is discount rate, which is influenced by interest rates—the higher the discount rate, the less valuable future earnings are. So rising rates can make stocks look more expensive. But as any discounted earnings or cash-flow model will show, a rising discount rate can be easily absorbed if earnings growth or cash flows are robust. It's when earnings growth is too low (or negative) that a tightening Fed has an outsized impact on valuation. This is exactly what happened from the second half of 2014 through the first quarter of 2016, which is why that part of the Fed hiking cycle was so challenging.
If I had been told back then that the Fed would end up tightening three times in six months and that financial conditions would now be easier (and the dollar lower and stocks much higher),I would probably not have believed it. But this is where we are today. (See chart below)
Looking at it purely in terms of real rates (after inflation), things are about the tightest they have been since the Fed started tapering in 2013/2014. But somehow, financial conditions have almost completely round-tripped from where they were before the cycle started, while inflation expectations are lower.
Why? These Goldilocks conditions are largely due to the new up-cycle for earnings growth and the synchronized global upturn that caused it.
The valuation math is simple: If future cash flows are being discounted and those cash flows are negative, any increase in the discount rate has an outsized negative effect on valuation. But if that cash flow turns positive, the asset in question becomes much more resilient despite a meaningful rise in rates. This is what changed in late Q1 of 2016.
As long as earnings and cash flows continue to grow (as seems likely), the Fed can keep tightening and should be able to return policy to the "old normal" (a 3%-plus Fed funds rate) without sinking the economy in the process.
Whether it can tighten as much as the dot plot suggests (1 more time in 2017 and 3 times each in 2018 and 2019) remains to be seen. Certainly the market is not pricing in these 7 potential increases, as the forward curve is signaling only two more hikes over the next 2 years.
For the Fed, this must be an interesting conundrum. Is the central bank happy that financial conditions are still so benign even though it has hiked rates 4 times? Or does it mean that the Fed must hike rates that much more to get to the normally desired outcome of tighter financial conditions? After all, that is why the Fed normally tightens.
I suspect it's the former. What a luxury problem it would be if the Fed can normalize policy to 3% without rocking the boat! However, if the latter proves true and the Fed hikes rates 7 more times between now and the end of 2019, this could be a long cycle.
Time will tell. Maybe the answer will come from the European Central Bank (ECB), which is sounding more willing to taper its QE program next year. If Treasuries have become more "fungible," i.e., capable of being substituted in place of other government bonds such as German Bunds and Japanese government bonds (in terms of their substitution effect in a QE-laden world), then an ECB taper might push U.S. real rates higher and cause financial conditions to become less benign.
The transition mechanism of this development would be an increase in the term premium, the amount of additional interest demanded by investors to hold longer maturity bonds, which remains about 170 bps (1.7 percentage points) lower than it should be as a result of global QE (according to my simple regression model, which attributes global QE as the cause for the lower-than-normal term premium).
However, a much higher term premium could have negative consequences not only on Treasuries, but on many other asset classes as well, all else being equal. That's because the risk-free rate either directly or indirectly affects the valuation of equities, corporate bonds, and real estate. But if GDP and/or earnings growth remains robust, perhaps the damage will be minimal.
Time to rebalance?
In the meantime, I continue to favor international equities over U.S. stocks, as I have all year. The reasons are 3-fold: Valuations are lower, earnings growth is as strong (if not stronger) overseas as it is in the U.S., and there is a lot of mean-reverting left to do after a 5-year period of continuous underperformance.
Chances are that the typical U.S.-based investor who hasn't rebalanced his or her portfolio in recent years is going to have a lopsided allocation to U.S. stocks.