Inevitably, in a week when the Fed’s Open Market Committee (FOMC) meets, the market’s focus will be on that meeting and any changes or announcements that come out of it. Going into this month’s meeting, most observers are expecting a rate hike, probably of one quarter of one percent, or twenty-five basis points in market-speak, yet the general feeling is that stocks will end the week higher.
That seems contradictory as rate hikes are usually considered bad for stocks, but in the current environment it makes perfect sense.
The main reason for that is simply the starting point. The last recession, remember, started as a credit crisis, where the borrowing and lending that fuels the economy froze up. The Fed’s response to that at the time was to drastically cut interest rates to the point where borrowing short-term money was essentially free.
That policy of ultra-low rates, combined with the added monetary stimulus of QE, did what it was supposed to do, and allowed for a sustained recovery. The depth of the recession was such that it did so without encouraging inflation, and that has enabled the Fed to keep rates low. Even now, after rates have begun to gradually recover, the 10 Year U.S. Treasury Note returns well under 2.5% per year.
That is important because big institutional investors use Treasuries as a benchmark against which to judge the desirability of other investments, most notably stocks. If stocks can realistically be expected to return more that the safe investment of U.S. Treasuries they will be bought, and history shows that beating a 2.5% return on a 10-year investment by buying stocks is almost certain.
The above chart shows the total return of an investment in the S&P 500 for rolling 10-year periods, beginning in 1937. As you can see, once the effects of the Great Depression ended in 1941 there have been only four periods when stocks returned less than 2.5% over ten years during the last seventy-six years. That, fundamentally, is what is driving money into stocks.
When the FOMC meets this week, they are likely to add another quarter point to the target Fed Funds Rate, but that is expected and is already priced into bonds, so the effect of the hike will be limited. More importantly, the fact that they feel confident that the economy is strong enough to take a rise in rates will be taken as an indication that they believe the outlook is good.
Based on what has been said in the past and on where the job market and inflationary indicators such as PPI and CPI are, it is also likely that Janet Yellen, in her comments and press conference following the meeting which will start at 2 pm Wednesday, will once again stress that the steady pace of rate increases will continue.
What we have now is almost a perfect storm for stocks. We have consistent, if slightly slower than optimal, growth, both in the U.S. and elsewhere around the world, and low interest rates. That encourages borrowing and investment by businesses, but more importantly it makes the risk of investing in stocks rather than playing it safe in Treasuries worthwhile given the historical returns.
A twenty-five basis point hike on Wednesday and a continuation of the gradual, cautious approach to normalization will not change that. If anything, it will indicate that that situation is set to remain for some time, so a rally in response to a rate hike is not only possible, but likely.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.