As expected, the Federal Open Market Committee decided to hike interest rates after its long-awaited two-day meeting last week. In response, the stock market - which had been rising in anticipation of the decision - rose even more. Yet over the next two days, stocks dropped substantially while the yield on the 10-year Treasury remained slightly below 2.2%.
Also pushing stocks down at the end of last week was a range of factors - including the falling price of oil, the Bank of Japan's monetary policy decision and lackluster earnings. However, it seems that much of the downward pressure was driven by negative sentiment about the Fed's rate-hike decision. So does that mean we should be nervous about stock-market performance in the coming weeks and months?
Not as much as many might think. The market's reaction isn't surprising, given how symbolically meaningful this rate hike was - the Fed's first in nearly a decade. Remember that in the wake of the global financial crisis, the US and many other developed economies faced extremely difficult economic environments and limited options.
For its part, the US chose a very different response to this major crisis than the last one, the Great Depression: The Fed made extraordinary changes to its monetary policy while the government implemented a relatively small amount of fiscal stimulus.
Take a look at the Fed's swift and highly unconventional policy actions during the Great Recession:
- In September 2007, the Fed cut its key interest rate, the federal funds rate, to 4.75%; it had been 5.25% since June 2006.
- By November 2008, after a rapid series of cuts, the fed funds rate stood at 1%.
- In December 2008, the fed funds target rate was cut to the 0% to 0.25% range, where it remained until last week.
Clearly, the Fed's decision to raise rates after seven years was a historic one, so it stands to reason that the markets would have a strong reaction. Having said that, we can't help but remind investors that stocks have historically done poorly in the initial months of a rate-hike cycle, but the asset classes that performed well in the first month after an initial rate hike were not the same ones that did well during the ensuing 12 months.
In addition, investors seem to be spooked by the FOMC members' policy prescription of four rate hikes in 2016, especially given that fed funds futures show market participants expect only two rate hikes next year.
Only 2 Hikes in 2016?Fed funds futures show that market participants think
the Fed will only lift rates to 1% at the end of
next year-implying fewer rate hikes than the FOMC suggested.
Source: CME Group. Data as of 12/18/2015.
While that is cause for confusion, investors should be encouraged by the Fed's commitment to making the path of rate hikes data-dependent. That means economic data - and not FOMC members' preconceived notions of where rates should finish in 2016 - will determine the path of rates. And with the amount of mixed economic data we're seeing, the Fed may not raise rates again for at least several months. What's more, even if the Fed were to finish 2016 with a fed funds rate at 1.5%, that is a very accommodative rate by historical standards - well below the average fed funds target rate of 5.49% since 1971.
So while the situation still bears monitoring, it's not cause for despair. Just recognize that capital markets may take time to adjust. That means investors should expect a continuation of the kind of volatility we saw last week and look to take advantage of the investment opportunities that volatility creates.