Fed Rate-Hike Fears Are Growing, And Here’s How You Know

The economy is surging as the jobless rate has plunged near a 50-year low, and five more Fed rate hikes are cued up over the next 18 months — including one at Wednesday’s Fed meeting.


Yet something about this show of economic strength doesn’t quite add up. Even as firming inflation and Fed rate-hike expectations have pushed up short-term government bond yields, the flattening yield curve is signaling growing doubts about the durability of the economy’s momentum.

Wall Street economists are split as to whether the Fed will hike once or twice more this year after Wednesday. If Fed economic projections released with their policy statement on Wednesday point to a likelihood of just one, the Dow Jones industrial average, S&P 500 index and Nasdaq composite are expected to rally, as Treasury yields pull back.

Yet there’s a big question about how long any relief rally can run when the Fed’s footsteps seem to be closing in.

Fed Rate Hike Patience?

On Tuesday, the 2-year Treasury yield rose to 2.54%, closing to within 42 basis points of the 2.96% 10-year Treasury yield. That’s within a whisker of the narrowest yield gap (41 basis points) since 2007, when long-term rates fell below short-term rates, a reliable precursor of recession.

In other words, a Fed that bucks up stock market investors with its display of patience still may not be patient enough.

The flat yield curve helps explain why both homebuilders, which thrive on low interest rates, and banks, which can benefit from rising rates, are among the market’s biggest laggards. The Building-Residential/Commercial group is ranked No. 186 of 197 industry groups tracked by IBD based on stock performance, while the Banks-Money Center group is a lowly 171.

On Tuesday, shares of JPMorgan Chase (JPM) and Bank of America (BAC) slipped below their 50-day moving averages. Meanwhile, CFRA analyst Kenneth Leon said KB Home (KBH) and Toll Bros. (TOL) could struggle amid a less-than-stellar spring selling season for homebuilders.

Fed Rate Hike Challenge

The Fed, under new chair Jerome Powell, faces an unprecedented policy challenge. Fiscal stimulus has always been ordered up during a recession or at the start of a recovery. This time, President Trump and Congress are delivering a double dose of major tax cuts and spending hikes deep into the expansion, when growth was already firm and labor markets tight. Now it’s hitting as core inflation has finally accelerated close to the Fed’s 2% target.

Keep in mind that last summer, before Trump’s tax-cut push gathered steam, markets were pricing in a single rate hike over the ensuing 12 months. The challenge is that policy works with a time lag. So almost as soon as the Fed adjusts policy to respond to economic strength, stimulus will be fading.

“We are clearly more concerned than the Fed” about the economic outlook for 2019, wrote Harm Bandholz, chief U.S. economist at UniCredit Bank, when policymakers released their projections in March. “As the impact of the (tax cut and spending) stimuli fades, growth rates should begin to slow perceptibly around the middle of the year, before slowing further into 2020.”

The potentially good news is that Fed policymakers have taken note of the flattening yield curve and plan to exercise caution so that the curve doesn’t invert, with longer rates slipping below short-term rates. Even still, getting the timing right won’t be simple.

“2019 is setting up to be a dangerous year, as the fiscal stimulus rolls off while the impact of the Fed’s tightening will be peaking,” Greg Jensen, co-chief investment officer of hedge fund behemoth Bridgewater Associates, wrote recently.


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