We’ve been telling our clients for a while now that one of the biggest risks to the longevity of the current bull market is how the Federal Reserve increases interest rates from the historically low levels that date to the depths of the Great Recession.
The Fed must walk a tightrope. Raise interest rates too quickly, and it will restrain economic growth. Raise interest rates too slowly, and it may spark inflation. Neither scenario is good for investors.
It’s a tricky balancing act for the Fed – and one that’s hard to get just right. Thus the risk to the bull market.
As evidence, look no further than comments made in October and then in November by Federal Reserve Chairman Jerome Powell.
On Oct. 3, Powell spooked the markets when he said that interest rates were “a long way from neutral,” the coveted spot that theoretically keeps the economy at full employment while simultaneously keeping inflation on a short leash.
Why did this rattle markets and begin what became a 10-percent correction? His comments implied that the Fed still has many more interest-rate increases up its sleeve.
On Nov. 28, Powell whispered to the markets again. Rates are “just below the broad range” of estimates of neutral, he said. The implication? Rates won’t rise much more because they’re already close to a normal range. This sent stocks soaring to their best day in eight months.
Powell’s comments may seem contradictory. But they are both correct.
How? The Wall Street Journal’s James Mackintosh explains it this way:
Fed policy makers estimate the neutral rate at 2.5 percent to 3.5 percent, with a median of 3 percent. Thus, it was true in October that current federal-funds rates of 2 percent to 2.25 percent are a “long way” – three or four more increases – from the median of 3 percent. It was also true on Wednesday that 2 percent to 2.25 percent is “just below” – one or two increases – the bottom of the range.
The takeaway from all this is that markets clearly are very sensitive to interest rates.
And it shows why we think that the biggest known risk to continued market gains is whether the Fed can continue to keep both feet perched on the interest-rate tightrope.