The Federal Reserve kicks off its two-day policy meeting on Tuesday with high expectations for another interest rate hike just three months after the last increase in December. If it happens, it would represent a marked acceleration of the prior pace of monetary tightening: Just two quarter-point hikes in the last 10 years.
Such a move will increase pressure on the economy at large, touching everything from auto sales to fixed-income valuations. And at a time when the stock market is looking increasingly vulnerable -- amid narrow buying interest and extreme sentiment -- this could be the catalyst the pushes stocks into at least a 1 percent sell-off, something that hasn’t been seen since October.
Current futures market odds put the probability of a rate increase this week at 93 percent as a combination of hawkish commentary from policymakers including Chair Janet Yellen, evidence of firming inflation and ongoing strength in the labor market confirms now is the time to quicken the tightening campaign that started in December 2015.
Looking further out, the CME’s FedWatch tool puts 54.4 percent odds on at least another quarter-point rate hike in June and more than a 30 percent chance of at yet another one by September.
The market’s pricing in such an aggressive rate hike schedule explains a reversal in key areas of the post-election “reflection” trade over the past week. The fear is that that Fed could be moving too quickly at a time when recent “hard” economic data points have weakened. Indeed, the Atlanta Fed’s GDPNow real-time estimate of first-quarter GDP growth is now down to just 1.2 percent.
Thus, the PowerShares DB Commodities Tracking Index Fund (DBC) has careened below its 200-day moving average in a way last seen in the summer of 2014 as the OPEC-induced oil price meltdown was just beginning. This time, fresh weakness in crude oil and precious metals is to blame (chart above). This suggests the Fed could possibly be set to lean too hard against inflation.
Investors are similarly selling both high-yield and investment-grade corporate bonds as well as rate-sensitive stocks. Anticipation of higher credit costs is upending familiar valuation models. For years, Wall Street has been spoiled by ultralow interest rates and the assumption the Fed would find any and all excuses to delay rate normalization. Thus, both stock prices and bond yields moved higher together.
Now, everything is expensive. Interest rates are coming off the lowest levels in recorded history. And stock price valuation metrics have been higher only during the run ups to the 1929 and 2000 market crashes.
In a “normal” business cycle, this wouldn’t be so bad because bonds and stocks tend to be inversely correlated. That is, when one does poorly, the other typically doesn’t. This keeps investors honest. And it encouraged healthy skepticism and asset diversification.
But not this time. And now as the trade reverses, “risk parity” funds have been hit as stocks (mainly, small-cap issues), corporate bonds and U.S. Treasury bonds have all weakened over the last few weeks.
For consumers considering buying a home, a car or otherwise financing a big purchase, some sticker shock is coming as higher borrowing costs limit purchasing power. The yield on the 10-year Treasury note touched 2.62 percent on Monday, the highest since September 2014.
If three quarter-point rate hikes do materialize this year, it would push the 10-year yield to roughly 3.4 percent -- a level not seen in six years.