“To hike, or not to hike, that is the question.
Whether ‘tis nobler in the mind to suffer the slings and arrows of outrageous tweets,
Or to take action against a sea of volatility,
And by opposing end them: to pause, to hike
One can almost see Fed Chairman Jay Powell, deep in contemplation holding a skull artistically representing the spirit of his predecessors – the latest string of which has left him in this quandary. The Federal Open Market Committee is scheduled to meet next week with a decision announced on Wednesday accompanied by forecasts, comments, and a Q&A session. What is a monetary policy maker to do after a string of quarterly hikes has lifted the short-term yields up to a level that caused the curve to invert in its middle? Financial conditions have been tightening beyond just the rate increases as the Fed continues to shrink its balance sheet and volatility has caused confidence in growth to fall. Meanwhile, inflation is tame, unemployment remains low, wages are growing but not at too fast of a pace, defaults have not ticked higher, manufacturing still looks to be expanding, and corporate earnings are growing. How much is enough? The market clearly has an opinion – the yield curve reflects what bond investors think and the equity volatility shows a concern for growth globally. Futures tied directly to the Fed Funds rate imply that the Fed will hike in December (76% probability as of Friday December 14th) though the probability of future hikes in 2019 has diminished significantly even from mid-November when the equity markets were already in or near correction.
So are we one-and-done? Would that even be a good thing? Assuming the Fed hikes next week (as is expected), the communication accompanying the decision Wednesday will be key. If the Fed does only raise rates in December and not at all in 2019 the reason would be that growth fears have come to realization. That would not be a good thing for risk assets in general. That said, we clearly believe a measured and data-dependent path (as has been suggested by policy makers) is necessary and the markets have to believe it. Financial markets and economies function as much on confidence (driven by perception) as fundamentals in the short-term. In fact, it can impact fundamentals. Giving the perception that the once-a-quarter pace will continue unabated in the current fearful environment may be self-fulfilling as perception of an impending downturn holds back consumption, capex, and hiring which could cause the cycle to end. Despite the overhang of growth risks reported on daily (no-deal Brexit, populist unrest throughout Europe, flailing growth in China, trade tensions, and so forth), there is still a reasonable path to solid economic expansion. They say that every story has been written, and as experienced investors we have certainly seen this show before. However, unlike the Bard’s tale, the conclusion of this story is not fait accompli.