Fed Focus

Last week’s stronger economic data in the U.S. and China included retail sales, initial filings for unemployment benefits, rail car traffics, mortgage applications, exports, and consumer sentiment. The generally better-than-expected economic data from China and the U.S. last week was unable to power stocks in either country above the resistance levels that have capped this year’s rally during the past month. One of the reasons for this may be that the good news on the economy raises the probability that China will seek to curb loan growth and the Federal Reserve will hike interest rates sooner.

This week’s Fed meeting (December 16) will be a major focus of market participants. We do not expect any material change in the Fed’s message to the markets, but investors are wary that the economic improvement might cause the Fed to signal rates hikes. The probability priced into the futures and options markets that the Fed will hike rates by mid-year 2010 has doubled to about 50% since the end of November. While we continue to expect a hike in the second half of 2010, the market is focused on the Fed’s message regarding potential future rate hikes. The recovery rallies in 1993 – 94 and 2003 – 04 were capped by the change in the Fed’s message, which signaled rate hikes were coming.

Fed Focus

Stocks React to Fed Signal

Watch Fed Signals

When the Fed signaled rate hikes in 1994 and 2004, the stock market rally gave way to a sideways, volatile period over much of the next 12 months. On February 4, 1994, without a prior signal, the Fed began the first of a series of rate hikes. On January 29, 2004, the Fed removed the phrase “considerable period” referring to how long they intended to keep rates low as a signal that rate hikes were coming (they began to hike rates five months later at the end of June). While peak-to-trough the S&P 500 declined about 8-9%, what took place after the Fed signaled their intention to begin a series of rate hikes is more accurately characterized as a sideways, volatile environment for stocks.

We do not expect rate hikes until the second half of 2010, nor do we expect the Fed to signal the markets that rate hikes are coming for several more months at the earliest. We do, however, expect China to remain committed to loan growth in the coming months. This outlook for continued economic stimulus, combined with improving and broadening economic growth, should help to renew the stock market rally through early 2010. Nevertheless, market participants will be watching closely this week for any signs that the Fed will seek to withdraw stimulus efforts prematurely.

Recently, the stock market has not reacted as positively to good economic reports as it had been for much of the past nine months. This may be because much of the recovery has now been priced in to the market. Rather than reinforce the durability of the recovery, market participants may interpret stronger-than-expected data on the economy as only increasing the potential for the Fed to begin to withdrawal stimulus earlier, and therefore begin to act as a negative. In the coming months, too much good news may turn out to be bad news for investors.

IMPORTANT DISCLOSURES

  • The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
  • Investing in international and emerging markets may entail additional risks such as currency fluctuation and political instability. Investing in mall-cap stocks includes specific risks such as greater volatility and potentially less liquidity.
  • Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.
  • Small-cap stocks may be subject to higher degree of risk than more established companies’ securities. The illiquidity of the small-cap market may adversely affect the value of these investments.
  • Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price.

Creative Commons License photo credit: beastmanphotos

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