Fed to hike earlier than expected

With the United States Federal Reserve having officially ended its quantitative easing program, thoughts naturally turn to the outlook for US interest rates.  When will the Fed start raising the Federal funds rate from current near-zero levels, and what will this do to share prices?

Financial markets currently expect no more than two 25 basis point US rate hikes next year, and not before the second half of 2015. To my mind, however, the balance of risks favors the Fed moving earlier – in the first half of the year – which raises the risk of another equity market correction in coming months. That said, history also suggests that Wall Street should eventually shrug off Fed tightening provided the economy continues to improve.

There are two reasons why the Fed seems likely to move earlier rather than later. For starters, financial markets still seem overly complacent with regard to the Fed’s intentions.  Released in late September, the median forecast for the end-2015 Federal funds rate among Federal Open Market Committee members was well north of 1%, compared with current market pricing of a lift to only around 0.5%.  If the Fed seriously intends raising interest rates that high that fast, it will likely need to start by the first half of 2015.

Supporting this view, the US labour market is fast approaching its so-called “full employment” level – and the Fed’s policy delay has already been extraordinarily long. As seen in the chart below, it is now 5 years since the US unemployment rate began declining, with as yet no lift in the Federal funds rate from “emergency” levels. In the previous three tightening cycles, the Fed began to lift interest rates between six and eighteen month following the peak in the unemployment rate.

If its current downward trajectory is maintained, the US unemployment rate would drop another 0.4% by late April, to around 5.4% – or just under the 5.5% rate assumed by the Fed as the long-run sustainable rate.

Under this scenario, leaving interest rates at the “emergency” level of near-zero for several more months beyond April – as the market current expects – seems untenable.

If the Fed does move earlier, what will this do to Wall Street? While a brief corrective period seems likely, the good news is that the Fed would be raising interest rates because the economy is getting better. History shows that even aggressive periods of Fed tightening are not necessarily associated with sustained share market weakness – due to ongoing strength in corporate earnings.   Over the last three significant Fed tightening cycles – beginning in 1994, 1999 and 2004 –  the S&P 500 US equity index rose by 16.8%, 1.4% and 31.5% respectively, for an average gain of 16.6%.

Perhaps Wall Street suspects the likely negative share market reaction to Fed tightening will automatically cause the central bank to postpone policy tightening yet again. For the sake of longer-term financial stability, however, we can only hope the Fed will find the courage to act in a timely manner. Although US inflation is low, America’s economic emergency has long passed – and so should the emergency level of near-zero official interest rates.

For more of David Bassanese's Market Insights, visit the BetaShares blog. For more information on BetaShares funds, go to the BetaShares website.