What the Fed’s Latest Interest Rate Hike Means for the Stock Market

“Fed watching” is among the most important tasks of traders. The Federal Reserve and central banks around the world have often had large impacts on stock market trading. This is because the central banks set interest rate policy.

Stock markets are often driven by the outlook for interest rates. This is because interest rates are a baseline benchmark in the stock market and they provide a signal related to economic growth. Policy changes are interpreted to indicate changes in central banker’s outlook about the economy.

For example, if the Fed is raising interest rates, this is a signal to the markets that they believe the economy is expanding. One Chairman, William McChesney Martin, famously said the Fed’s job is “to take away the punch bowl just as the party gets going.”

In other words, higher interest rates are intended to slow the economy as it reaches a level of heated activity after a recession. If the Fed fails to slow the economy, economists fear inflation will take hold and higher inflation brings numerous problems to the economy.

Martin understood the limits of the job. After being appointed Chairman in 1951, he explained to The New York Times in 1985 that he thought,

”My gracious, here I am, the new Chairman of the Fed, and I’m doing my best. I’m not the brightest fellow in the world but I’m working hard on this, and I haven’t the faintest idea of how you figure the money supply. Yet everybody thinks I have it at my fingertips. They don’t really know what the money supply is now, even today. I’m not trying to make fun of it but a lot of it is just almost superstition.”

Despite the fact the Chairman didn’t feel he had adequate information, traders feel they need the information he has. This has led to various indicators, including one based on how thick the briefcase of one of Martin’s successors, Alan Greenspan, was.

The Briefcase Indicator

Greenspan walked to work. This proved to be a bonanza for financial news channels in the late 1990s. On mornings when the rate setting Federal Open Market Committee (FOMC) met to discuss monetary policy, cameras captured Greenspan carrying his briefcase into the Federal Reserve Board building.

Source: CNN.com

If the briefcase was thick, the theory argued it was filled with proof that changes to policy were needed. A think briefcase meant traders should expect no changes in policy.

Economists at the St. Louis Federal Reserve studied the briefcase indicator. They concluded this wasn’t really a valuable market indicator.

“Unfortunately for the Fed watchers, the size of the briefcase is not always a good predictor of the Fed’s actions. A look at the May 2000 FOMC meeting highlights this point.

Despite the fact that Greenspan’s briefcase was reportedly at its thinnest in years that morning, the FOMC raised its interest rate target by half a percentage point, its largest increase in five years. Therefore, it’s not the size of the briefcase that matters, but the type and quality of information found inside.”

The economists noted that the briefcase probably contained data released by government statistical agencies. The question is, what does the data tell the Fed about the economy that will cause the FOMC members to make a decision to change policy.

Although the current Chair, Janet Yellen, doesn’t carry a briefcase in front of cameras, the data is still available and at the Fed’s most recent policy meeting, the data drove some important changes in the Fed’s outlook.

Fed officials are now more optimistic about the future than they were just three months ago.

Current Fed Economic Projections

The biggest news to come out of the Fed’s recent meeting was the fact that the Fed raised interest rates. The Fed raised its benchmark short term interest rate a quarter point to a target range of 1.25% to 1.5%. This increase is in line with the Fed’s outlook.

Members of the Federal Open Market Committee raised their GDP estimate from 2.1% in September to 2.5%. This may sound like a small change but is equal to hundreds of billions of dollars of output in the large economy. In future years, the Fed expects a return to slow growth.

GDP

Source: Federal Reserve

The inflation forecast for 2018 was also increased slightly, from 1.6% in September to 1.7% now. In the long run, inflation is expected to average about 2% a year.

inflation

Source: Federal Reserve

The statement the Fed released indicated they see improvements in the jobs market. The statement noted employment “will remain strong.” Analysts noted this was an upgrade from the assessment at the Oct. 31-Nov. 1 meeting where officials stated that conditions “will strengthen somewhat further.”

Long term projections of the Federal Reserve indicate they expect the unemployment rate to stabilize around 4.5% in the long run.

unemployment

Source: Federal Reserve

But, specific forecasts for 2018 show unemployment is expected to be near 3.8% with an increase to near 4% in 2020.

Implications of Federal Reserve Forecasts for the Markets

The Fed’s forecasts are generally bullish for the stock market.

Growth in the economy is an important factor in the trend of the stock market. In general, when the economy, measured by changes in gross domestic product or GDP, is rising, we expect stocks to be rising. Contracts in GDP are often associated with bear markets in stocks.

For 2018 and 2019, the Fed is expecting GDP growth to be above average. In the long run, they expect growth to average between 1.8% and 1.9% a year. This is relatively slow growth and could result in relatively slow growth for stocks.

This is shown in the next chart which compares the one year change in prices of the S&P 500 and the rate of change in real GDP. Real GDP ignores inflation which is often done with economic indicators since inflation distorts the underlying trend.

real GDP

As this chart shows, changes in real GDP and the S&P 500 index tend to be highly correlated. Uptrends in GDP tend to be associated with uptrends in the stock market and downtrends in both tend to occur at the same time.

In addition to correlations in the direction of the trend, there is also a relationship in the magnitude of the changes. Large changes in GDP, whether the direction is up or down, tend to be associated with large changes in the S&P 500. Small changes in GDP tend to be associated with small changes in stock prices.

Based on the relations in the chart above, the Fed’s forecast for slow growth can be projected to indicate slow growth in stock prices moving forward. Investors looking for gains averaging 10% a year or more are likely to be disappointed.

The Fed’s forecasts are also consistent with low interest rates for some time. Low inflation will allow the Fed to maintain low rates and that could continue to drive funds from fixed income investments into the equity markets, potentially delivering gains that are larger than the ones fundamentals point to.

Slow growth and low interest rates provide a message from the Federal Reserve to stock market investors. It may be unrealistic to expect large average returns going forward. This means stock selection will be important.

Index funds may not be the star performers in the future as selectivity comes into focus. Disciplined strategies, with a focus on managing losses, could provide market beating results in the future the Federal Reserve is telling investors to expect.

Fed watching is one of the ways traders seek an edge in the market. Edges require disciplined trading strategies. If you are concerned that you don’t have time to dedicate to implementing a strategy, consider using a service.

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