The first thing the market did following the first Fed rate hike in nine years was breathe a sigh of relief – and then react. In a perverse way, the market seemed to be applauding a tightened policy, which is counter to what we have seen for years. Sure, the near-zero interest rate policy (ZIRP) is still in effect, but the market’s irrational behavior is quite remarkable. While the overall monetary policy is accommodative, a removal of access via higher rates is hawkish behavior any way you slice it.
As traders, we want to do know what the Fed’s rate hike means. Recall that Marty Zweig said so many years ago, “Don’t fight the Fed!” The Fed controls liquidity, which affects the behavior and psychology of the market players. Right now, the market is in the process of adjusting to a new policy paradigm, and over the long term that will be good for the stock market and the economy.
But what of that irrational behavior? Should we hang up our spurs and move away from the markets, at least for the short term? That would require timing the market, which is nearly impossible to get just right. Plus, if we look at prior rate hike cycles, they are likely to be quite different from this one, so historical behavior is not on our side either.
The Fed kept rates very low for a very long time. Many have argued the substantive effects of such a generous policy stance and the efficacy, but we’re not discussing that today. Rather, we need to understand why the Fed is changing policy and whether this is a give back following the emergency measures they took in 2008-09.
Unfortunately, understanding their policy directive is not easy. As usual, the Fed left us with some holes, as they are following the data and will adjust on the fly. That approach doesn’t work well for markets. The markets want their cake (transparency) and they want to eat it, too (certainty). The Fed’s rate hike may be based on their belief that the economy’s prospects are improving. The employment outlook is better, but inflation is not rising much, and in an economy floating around 2%, there is just not much to be excited about. The bond market and a strong dollar are telling us that, too.
Strikingly, bonds were up following the Fed hike, telling us they are not believing the Fed’s case. The yield curve has flattened, bonds on the long end of the curve are rising, and volatility is elevated. Simply put, the bond market is not believing the story. Neither is the equity market, which can get hurt if the Fed institutes more rate hikes (even gradually).
There is no question that the Fed’s rate hike left them stuck in a box and now they’re trying to get out. Do they have skills of a Houdini? We’ll have to see.