Fed Heading Further Down That Rabbit Hole

A fed rate hike this Wednesday is imminent, but will the markets flinch?

Interest rates have gone in one direction since the last market crash, and that is down. It was not until the beginning of this year, that the fed made its first rate hike in 10 years, resulting in a mini flash crash and the fed holding off on an additional rate hike until the economy “improves.”

Now it is the end of 2016, and the fed has yet to warrant a second rate hike… until now.

Since the surprising election results in November, investors have been positioning for the individual and business tax cuts expected under a Trump presidency, resulting in a rallying stock market, the S+P closing at a record high of 2,259 on Friday, and an increase in consumer confidence, the index gaining 6.3 points after retreating in October.

Scott Anderson, Chief Economist for Bank of the West, said,

“The surprise of the Republican sweep of Congress along with the Trump administration has really changed consensus expectations almost 180 degrees. We really are focusing in on some of the impacts that some of the policy changes could have. We may be shaking up the economic world in terms of what we’ve been waiting for, what the Fed has even been saying — we need Congress and fiscal policy to do some of the heavy lifting here. I guess in some cases the Fed isn’t really leading the story as much as they had in the past, and in some ways the Fed is really following the market right now in terms of raising rates.”

Anderson sees the fed as optimistic about the economy due to growth concerns over Brexit fading. Anderson said…

“Optimistic in the sense that a lot of the growth concerns they’ve had following the Brexit vote, a lot of those things have come and gone, and so those downside risks to the global outlook have faded and that will give a green light for the Fed to move forward here… It’s not just the US we’re seeing synchronized global growth rebound here following the Brexit vote, which nobody had really factored into their growth forecasts.”

In addition to the Fed meeting this week, there are also Treasury auctions Monday and Tuesday for 3-year and 10-year notes and 30-year bonds. In anticipation of the auctions, many strategist feel as though yields have moved ahead, with the curve being the steepest it has been between the 2-year and 10-year since last December.

Both Anderson and Deutsche Bank Chief U.S. economist, Joseph LaVorgna view the increase in treasury yields and the steeping yield curve as healthy.  “Look at the rotation within the equity market, more toward cyclicals or those industries more sensitive to the economy. Those are the things I would focus on,” LaVorgna said. “We’re at the steepest yield curve in a year. That to me is an unambiguous sign of faster growth.”

The CME group federal funds futures put the probability for a rate hike at 97%. What will a rate hike mean to the markets? 

With the yield curve steeping and stocks rallying in anticipation, many strategist see the coming rate-hike as already priced in. “My guess is [the meeting] is going to be the definition of a nonevent. I don’t see any substantive changes coming from the Fed,” said LaVorgna, “They don’t have to tweak things in any appreciable way. It will be a place holder for the meeting in March, because then we will be halfway through the president-elect’s first 100 days.”

Furthermore, with the unemployment rate now at 4.6%, some say the Fed has let the labor market improve too much without moving rates. This means that the fed may have to raise rates at a faster pace in 2017. TD Securities analysts said that fiscal policy at this point in the economic recovery could prompt “an inflationary demand shock” that adds nearly a percentage point to economic growth, and prompts the fed to raise rates again much sooner than expected.

Just last week, New York Fed President, William Dudley, said, “the stock market has firmed, bond yields have risen and the dollar has appreciated… Market participants now anticipate that fiscal policy will turn more expansionary and that the FOMC will likely reposed by tightening monetary policy a bit more quickly than previously anticipated.”

With all that being said, the market may not feel this rate hike, but traders better watch their backs- The Fed could be raising rates again real soon, in a big way.

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