Rate hike fears return to haunt stocks

Despite last week's Federal Reserve decision to hold interest rates near zero percent -- delaying the first potential rate hike since 2006 -- the U.S. equity market isn't happy. Stocks opened Thursday with another dramatic plunge, pushing the Dow industrials back toward the 16,000 level for a loss of nearly 300 points before buyers cut the losses to 79 points by the closing bell.

But on a technical basis, much damage has already been done: The two-month uptrend that has held stocks since the Aug. 24 "Black Monday" lows has been violated. Nerves are frayed with safe-haven assets like gold and Treasury bonds enjoying a rise. Even the CBOE Volatility Index (VIX), Wall Street's "fear gauge" based on the value of option premiums, remains elevated.

After Thursday's close, in a speech to the University of Massachusetts, Amherst, Fed Chair Janet Yellen did little to soothe the situation. Focusing on inflation dynamics, she outlined why she and most of her colleagues believe conditions will warrant "an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter."

She also tried to downplay all the tension about the timing of the Fed's first rate hike: "By itself, the precise timing of the first increase in our target for the federal funds rate should have only minor implications for financial conditions and the general economy."

Market behavior says otherwise.

Recent selling pressure suggests the Fed is pushing for higher interest rates sooner than the market wants: Better-than-even odds of a Fed hike based on futures pricing cannot be found until early 2016. Current odds put a December rate hike at a 41 percent probability. Wall Street simply isn't ready for higher rates.

Why the consternation? It involves many issues.

Globally, the Bank for International Settlements recently warned that higher interest rates from the Fed will push up borrowing costs in emerging market economies, many of which are nursing dangerous credit overhangs and troubling economic slowdowns.

Here at home, corporate earnings are under pressure from low commodity prices and the negative impact on foreign earnings from a strong dollar (spurred on by expectations of higher U.S. rates). Ed Yardeni at Yardeni research noted that analysts are busily cutting their estimates for the third-quarter earnings season that starts on Oct. 8 when Alcoa (AA) reports. Currently, S&P 500 earnings are expected to fall 2.9 percent over last year's third quarter.

In real-world terms, we're seeing the impact on regular Americans. Caterpillar (CAT) shares dropped 6.3 percent on Thursday after the company cut its fiscal 2015 revenue forecast for the second time this year and announced it will slash 10,000 jobs by the end of 2018. Caterpillar warned that fiscal 2016 revenue would likely fall 5 percent year-over-year -- the fourth consecutive annual decline -- as a slowdown in China and cuts in the mining and energy sectors continue to weigh.

And the economic data has been taking a turn for the worse. The Kansas City Fed regional manufacturing activity index became the sixth regional Fed survey to start flashing red, coming in at -8 (vs. expectations for -6). That's its seventh negative monthly result in a row -- something that hasn't happened outside a recession. Not good.

Considering all this, why then is Yellen pushing so hard? Why not wait, as the market apparently desires, until conditions are better?

She gives two reasons.

For one, monetary policy acts with a lag of around nine months. If the Fed waits too long, cumulative improvement in the job market and early indications of wage inflation could force faster and more aggressive rate hikes in 2016 and 2017 -- potentially rattling markets and pushing the U.S. economy into recession.

The second is the risk of fueling a market bubble. Said Yellen: "In addition, continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability."

No one said central banking was easy. After supporting markets with cheap money stimulus for nearly seven years, the Fed chair seems committed to normalization. Wall Street bulls are suffering the pangs of withdrawal just thinking about the end of years of monetary morphine.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.