On October 3rd, in an interview with Judy Woodruff of PBS, Federal Reserve Chairman Jerome Powell uttered these words in a Q&A session: “Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.”
Within 36 hours, after the full impact of this statement had been absorbed, the 10-year interest rate had spiked from 3.0% to over 3.25%–a move of gigantic proportion. At the same time, equity markets sold off in an aggressive stance for a week straight—only to slightly settle last Friday, the 12th.
Yep, Just in time for the Halloween season the Fed is donning a mask and is putting a scare into financial markets. There’s no question that the latest market sell off has to do with a concern about higher interest rates. But once again, if you follow the politicians, the general news media, and even the financial press and market pundits, you’d be confused as to the potential ramifications of the latest developments.
I’ll attempt to concisely explain the context of this rate rise, the reasons investors need to be concerned and any silver lining.
How these things usually work
The natural state of a capitalist economy is expansion. That’s what we’re experiencing now. Expansions go on until they don’t. In other words, economies expand, continue to expand, over heat and then recess. In an attempt to prevent economies from becoming too hot, central banks will raise interest rates (as a refresher, central banks only control short term interest rates, long term rates are influenced by factors such as expectations for inflation and economic growth, corporate credit quality, and demand for fixed-income securities by U.S. and foreign investors). Raising rates, or “tightening”, has the effect of slowing down the economy. Unfortunately, getting the balance right—in other words, raising rates by just the exact amount—is a difficult task and central banks have a history of pumping the brakes for too long and too hard when attempting to contain growth and inflation. By doing this they have been the cause of many a recession.
Where are we now & what really matters with an increase in rates
Let’s take a step back at this point and examine where we are. We know that interest rates have risen as can be seen in the red line on the graph several paragraphs below. The main question is whether rising rates are bad for stocks? The conventional wisdom holds that stocks will decline once rates rise on a sustained basis. It’s true that higher interest rates mean increased borrowing costs for individuals and businesses, which lead to lower consumer and business spending. Additionally, higher rates mean lower valuations as the future cash flows are discounted back at a higher rate to the present. It’s also true that a spike in any macroeconomic indicator—let alone the most important variable—can cause some amount of uncertainty. But in actuality, the statistical evidence on whether higher rates are bad for stocks is very mixed. There are many examples to counter conventional thought where rates have risen along with stock prices.
Think about this: if growth picks up in the economy without excessive inflation (will get to inflation in a bit) then corporations will capture all sorts of additional revenues even at the expense of higher rates. At the end of the day what really matters is the rise in interest rates relative to growth rates in the economy (growth rates in the economy are also referred to an “equilibrium real interest rate” or a “neutral” rate). To the extent that growth rates either match or are higher than market interest rates then economic conditions will improve. But if interest rates in the market exceed these growth rates (“equilibrium rate” or “neutral rate”), then this will slow down the economy and potentially cause problems for the stock market.
So, back to Chairman Powell’s answer in the Q&A. By moving interest rates to “neutral”, what he’s saying is he wants to do is move market interest rates to a level that approximates the “equilibrium rate” or growth rate or “neutral rate” in the economy. Or, more realistically, the Fed’s best estimate of the equilibrium/neutral rate, which is not directly observable. But investors do have access to studies on what the so-called neutral rate is and how you get to it. Most of those suggest the neutral rate is somewhere between 2.5% – 3.0% or maybe 2.5 – 3.25%. At today’s Fed Funds rate of 2.25% they’re clearly below the bottom of the range. This is telling us that the cost of capital is still significantly below the economic growth rate, thus, the Fed is still in an “accommodative”, or supportive, position for the economy. Sure, the rhetoric has changed, but their actions must take a drastic turn for them to become restrictive.
A primary goal of the Fed is to fight inflation. Inflation, when present, erodes purchasing power and can be difficult to contain. It’s an important development that the higher long-term interest rates we’ve been experiencing do not seem to be driven by expectations that inflation will soar higher.
How do we know this? We can easily measure expected inflation by comparing the yield of inflation-protected bonds with the yield of traditional bonds. In fact, that’s what the chart below does. By looking at the flat blue line below you can see that yields of inflation-protected bonds have moved mostly in lock step with traditional bonds over the recent weeks & months, suggesting that traders haven’t become more worried about inflation.
For example, inflation of 2.16% a year over the coming decade was implied by the price gap between the two types of bonds as of the middle of last week, up only slightly since August and below its level in May.
The rise in longer-term interest rates is driven mainly not by a rise in inflation expectations, but rather by a rise in investors’ expectations for what the Fed will do and for how much compensation bond investors are demanding in lending over long time periods. Put more simply…the rise in interest rates appears to be driven by real growth expectations!
The Fed has indicated that it expects to keep raising their target interest rate to around 3.4% by the end of 2020, up from the aforementioned current level of just above 2%.
In previous years, financial markets had their doubts whether the Fed would follow through with its forecasts for rate increases. Now the Fed’s own projections are consistent with the path of rate increases priced into markets removing a level of hated uncertainty from the market.
So, growth without any undue inflation, which is simultaneously anticipated by bond investors is a healthy combination.
Given that the Federal Reserve has now shifted away from its so-called third mandate of financial stability, which dominated most of the post crisis period, and back to worrying about faster inflation, concern about too much tightening is warranted. This is true because the Fed has a difficult task of raising rates to cool the economy with just the right balance and we know that they have pushed the economy into recession many times in the past.
We also know that not all stock market corrections are caused by recessions. But that every recession causes stock market corrections. So, given the risk with the Fed’s future actions on rate tightening, the recent stock sell off (especially with stocks still at high valuations) was a rational response. Yes, the complexion of the market has changed.
At the same time, we have proven that the Fed, up until this point, has set interest rates just below the growth rate in the economy (and that their actions speak louder than words). This means that they can be supportive of further growth even in the face of higher interest rates. Furthermore, we’ve seen that, even in light of those higher rates, inflation isn’t a present concern and that the Fed’s own projections are consistent with the path of rate increases priced into markets. Again, all of this is supportive of an expansion that could very well continue.
The chances that the Fed finds the right balance over the intermediate period are slim. And yes, the dynamic could change in an instant. The risks are also elevated given the fact that the stock market is richly valued. For that reason it would not be surprising to see this correction continue. But it appears that in this exact moment that the amount of accommodation and low inflation expectations are still supportive of an expanding economy.