Today’s Federal Reserve Bank meeting was viewed by many as the most scrutinized and anticipated meeting in the Fed’s history. Market participants came into today’s meeting unsure of the outcome; would Chairwoman Janet Yellen and team raise interest rates for the first time in more than seven years, or would recent economic weakness and volatile capital markets keep the Fed from making a policy change? In this Market Thoughts, we discuss the meeting’s context, outcome, and client implications.
The U.S. Federal Reserve is charged with three mandates: supporting the economy as it seeks full employment, promoting price stability, and maintaining moderate long-term interest rates. The Fed’s primary toolkit to carry out these mandates centers on monetary policy, specifically controlling short-term interest rates. In times of economic expansion, the Federal Reserve targets higher interest rates to discourage lenders and borrowers from adding inflationary pressure to the economy. During economic stagnation or decline, the Fed may lower its interest rate target to jumpstart consumer and business activity by decreasing borrowing costs. Federal Reserve interest rate policies can impact everything from bank deposit rates to mortgages to stock valuation models, so both Wall Street and Main Street pay attention.
The Federal Reserve has not changed its key interest rate, called the federal (or fed) funds rate, since it cut the rate to its lowest level in history (a range of 0 percent to 0.25 percent) in December 2008. The fall and winter of 2008 represented a tumultuous time in the economy and capital markets. Credit markets froze, global investment bank Lehman Brothers went bankrupt, unemployment doubled from late-2007 levels, home prices fell 30 percent from the prior fall, and global stock prices were cut in half.
Significant intervention by global central banks in the U.S., Europe, China, Japan, and the United Kingdom followed. They slashed interest rates and initiated substantial asset purchase programs to encourage both lending and borrowing. Through stimulus programs and the tincture of time, economies, and capital markets began the recovery process. Since the economy’s nadir in late 2008 and early 2009, unemployment, housing, equity markets, and credit conditions have vastly improved in the U.S. and global economies.
While the recovery path has been uneven by region and country, in aggregate, the world is in much better economic shape than it was when the Fed cut interest rates to historic lows. Some market participants are concerned that, if the Fed does not move off of current levels, we could see inflation increase and harm the economy; others worry that while the global economy has improved, it remains fragile and the Fed would be preemptive in changing policy.
The Federal Reserve left the fed funds rate unchanged today. In its statement, the Fed noted “developments abroad” and inflation readings, both current and financial market-derived projections below the Fed’s 2 percent inflation objective, as key variables driving this decision. When asked specifically about global developments during a post-statement press conference, Chairwoman Janet Yellen first noted that China and emerging market economic weakness were concerning. She specifically cited Chinese equity price drops, oil price declines, and major trading partner Canada’s recent economic woes as central to the Fed’s decision to maintain current interest rate levels. These same concerns were reflected in global stock and bond markets in late August and, while some market tensions have eased in recent weeks, the Fed’s message is that the globally interconnected economy requires monitoring.
Market and Investment Strategy Implications
Today, bond prices rose sharply after the Fed’s announcement that it would leave interest rates unchanged. Typically, when the Fed raises the fed funds rate, the rest of the bond market adjusts through lower prices. Meanwhile, the equity market was mixed in a choppy session, with stocks unsure of how to interpret the potentially bullish notion of sustained lower borrowing costs and the Fed’s concerns about international developments impacting the U.S. economy. The most interesting development from today’s market movements is that the market now expects the Fed to delay an interest rate increase until after 2015, with a 50/50 chance of a rate increase in late January 2016. Before today’s Fed announcement and press conference, markets expected interest rates to increase later this year.
From a strategy standpoint, today’s outcome does not mark a significant transition from recent Fed statements or views, and developments do not change our forward-looking views about capital markets. We see the global economy as growing, yet remaining fragile. The Chinese and emerging market economic slowdown is real, Japan and Europe have some underlying momentum, but require ongoing stimulus for further progress, and the U.S. will grow below potential due to the rest of the world’s weakness.
Equity markets remain more attractive than bonds with a longer-term view, but valuations and sluggish earnings growth suggest investors will experience lower returns than historical experience suggests. Within the bond market, we also expect lower returns but, unlike some peers and competitors, we do not expect a significant increase in interest rates that could adversely impact bonds. We do expect interest rates to increase, but today’s Federal Reserve decision bolsters our view that interest rates will follow a very gradual path higher. We still see the glass as half full with respect to the capital market landscape, but lower return potentials suggest the glass may be a bit smaller than in recent years.
As always, please do not hesitate to let us know if you have questions.
Eric J. Freedman
Chief Investment Officer