The Federal Reserve (Fed) raised interest rates last week as we had long expected, lifting rates by a quarter point. This was only the third time the central bank has hiked rates since before the 2008 financial crisis. A series of Fed speakers began to telegraph this move in recent weeks, but its likelihood was given a low probability by the markets even a few weeks ago when we published a post on why a March hike was on the table.
We applaud the Fed for its courage in continuing to move rate normalization forward and in laying out a policy that suggests at least three moves this year on the road to rate normalization. With two more rate hikes potentially on the horizon in 2017, we also believe now is a good time to clear up a few wrong assumptions some market watchers are making about rate normalization.
Assumption #1: Risk assets are bolstered by extreme policy easing and are always hurt by the process of policy normalization.
The reverse was actually the case recently. This is highlighted by the chart below of end-of-year federal funds rate expectations and the price performance of the S&P 500 (SPX) Index.
The chart below also illustrates the reverse. It looks at a set of domestic and international markets and how they performed after the September 21 policy meetings of the Bank of Japan (BoJ) and the Fed. At those meetings, the BoJ critically shifted monetary policy to focus on rate targeting, rather than negative rates, and the Fed inched closer to its eventual 2016 hike in December. The actions of both banks resulted in yield curves steepening. The resulting performance of risk asset markets clearly indicates to us that market participants are more than comfortable with the idea of a monetary-to-fiscal policy transition, and in fact, they actively seek it.
Assumption #2: The Fed is now tightening and creating restrictive policy.
We believe nothing could be further from the truth. In our view, the elasticity of interest rate sensitivity is not linear and is in no way symmetric at different rate level thresholds. In other words, moving policy rates from 4% to 6% would essentially shift financial conditions from fairly restrictive to more restrictive, but moving rates at the lower end of the spectrum must be thought of differently. Indeed, we believe moving from negative real rates to modestly positive rates, as is happening today, is still extremely accommodative and supportive of the economy and markets. It also brings the financial system closer to an equilibrium.