Interest Rates: Don’t fight the Fed

Monique Frederick, Butterfield

In the current economic environment, in which the Federal Reserve has put a rate-hike campaign on hold and is set to end balance sheet reduction, citing increased risks to US economic growth, risk assets should outperform.

We finished 2018 with a depressing final quarter as all risk assets, corporate debt included, suffered losses nearly erasing all gains achieved in the first nine months of the year. Blame for this fourth quarter market downturn has been directed at the Fed, which maintained a hawkish stance and raised interest rates for the fourth time in 2018.

The Fed increased the target range for its benchmark interest rate by 25 basis points to a new band of 2.25% to 2.5%, putting the Fed funds rate at its highest level since the spring of 2008. This decision was taken despite signals of an impending global economic slowdown.

In contrast to the final quarter of last year, 2019 is off to a great start with the S&P 500 executing a perfect V-shaped bounce by returning over 13% in the first quarter, compared to the 13% decline which was witnessed in the fourth quarter. This was notably the best quarterly return for this broad US index since the third quarter of 2009, which saw a 15%+ total return. More impressive is the fact that this broad-based recovery has brought global markets in striking distance of all-time highs.

Contrary to this positive market performance, the International Monetary Fund cut its outlook for global growth to the lowest level since the financial crisis, amid a bleaker outlook in most major advanced economies and signs that higher tariffs are weighing on trade. The organisation in now anticipating 3.3% global growth for the year, down from the 3.5% forecast published in January. Against this backdrop of slower growth, what then has propelled markets?

The Fed dramatically changed its tone, from first projecting two rate hikes in 2019 to forecasting none at all.

Admittedly, the Fed is not the only central bank which has turned dovish; the European Central Bank and China’s central bank have also taken steps to stimulate their economies. The pivot to an accommodative stance undoubtedly affects interest rate-sensitive industries with the most interest rate-sensitive sector – housing – leading the way.

As a result of the Fed suspending its rate-hiking trajectory, mortgage rates are set to remain at current levels, resulting in a much better scenario for consumers than initially anticipated.

In 2018, US housing was a source of weakness as the rise in mortgage rates negatively impacted home sales and residential investments. Although March 2019 existing home sales disappointed, declining 4.9%, new home sales hit a 16-month high, increasing by 4.5% on an annual basis.

This recent housing data, does not necessarily suggest a major up-turn, but it does suggest some improvement in the housing sector. As the main driver of overall consumption, consumer spending, which represents 70% of GDP, is a key factor in determining the overall state of the economy.

Given that consumers’ greatest expense relates to housing, whether through ownership or renting, any positive trends in the housing market will positively affect consumer spending.

Additionally, household debt levels have come off their highs and the labour market has remained very resilient, with the level of jobs openings at a record high and initial unemployment claims at a 49-year low. With wages rising, households now have more income, leaving the US consumer in fairly good shape.

The current earnings season has also been a source of optimism as a surprising number of companies are beating earnings expectations.

According to FactSet, more than 75% of S&P 500 companies which have reported first quarter results have exceeded analysts’ expectations. Reports like these quell any fears of an earnings recession in the US and sets aside concerns of a global slowdown.

Of course, we should not just view the markets through rose-coloured glasses by ignoring the various risks which still remain. Geopolitical risks, including the US-China trade dispute and Brexit, have the ability to shave off some of the spectacular market returns achieved to date. However, in the meantime, as long as the Fed refrains from hiking interest rates, going against the Fed could result in leaving some profits on the table.

Disclaimer: The views expressed are the opinions of the writer and, whilst believed reliable, may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.