Stock Market Update – Fed Raises Interest Rates

Stock Market Update – Fed Raises Interest Rates

Fed Chief Janet Yellen raised interest rates 25 basis points. The new fed funds level becomes 25 basis points to 50 basis points. The Fed stated that future rate increases will be gradual, which is expected to be supportive for stocks. Future rate hikes will depend on a matrix including economic data, inflation prospects, labor market conditions and the performance of the global economy. The Fed’s policy statement has dovish overtones suggesting the Fed remain accommodative for both stocks and the U.S. economy. The Fed’s balance sheet will remain unchanged and they will continue to buy bonds as issues come due. Overall, Yellen’s actions are in line with expectations. Yellen provided the markets with sufficient notice that a hike was highly likely in December. Although this was the first rate hike in nine years, the impact on the markets is not anticipated to add to volatility.

Although the Fed announced a basket of data that will dictate the future course of monetary policy, inflation is likely to be the most important factor. For the past 15 years, economists have been forecasting higher levels of inflation but the surprises have been to the downside. Now, for the first time in recent memory, consensus views are that inflation will remain very low for a long period of time. Our posture on inflation is that it is likely to remain low but there could be an upside surprise in 2016. The collapse in commodity prices has offset the sharp increase in shelter and health care costs. Wages in recent months have exhibited an upward bias above the 2.00% level that has been the case of the past six years. Considering that inflation is most closely tied to household income, a rise in wages above 3.00% would argue that inflation forecasts are too low. Long term, however, the higher than normal levels of debt throughout the economy will continue to act as a headwind for interest rates and inflation. We expect the yield curve to narrow but from a slightly higher level.

Short term, the equity markets are expected to rise into early 2016. This is based on seasonal factors but investor psychology is also playing a role. Investors Intelligence (II), which tracks the mood of Wall Street letter writers, shows a surprising December drop in bulls to 38%. The bears in II data climbed to 29%. This also fits with the latest survey from the American Association of Individual Investors (AAII) which showed more bears than bulls in December for the first time since 2011. One of the most important keys to the potential of the equity markets early next year is the performance of the broad market. Once tax selling is exhausted, which typically occurs just before Christmas, we expect to rally to become more inclusive. Investors should focus on those sectors that continue to lead the market including technology, consumer discretionary and health care. The financial sector should benefit from widening interest rates spreads. A leading bank today raised the prime rate but left the despot rate unchanged.

Bottom Line: Fed removes uncertainty over rate hike – broad market should expand beginning late next week.

© Robert W. Baird

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