Rates on the Rise

 

“At our meeting later this month, the Committee will evaluate whether employment and inflation are continuing to evolve in line with our expectations, in which case a further adjustment of the federal funds rate would likely be appropriate.”

Fed watchers always love to pore over the text of the Fed Governor’s speeches looking for clues as to interest rates. Looking at that one sentence from Janet Yellen’s speech on March 3, it doesn’t require a microscope to read the writing on the wall…rates are going higher.

Assuming the Fed does raise rates later this month, this will be the third interest rate increase in the last 16 months. With most recent raise in December, the pace of increases is certainly increasing.

Historically, higher interest rates result in fairly predictable market behavior. The dollar rallies, gold sells off, bonds sell off and stocks are generally less attractive. However, the stage for this rate increase hasn’t been set in a traditional manner and I don’t think investors should blindly expect a traditional market response.

First off, the dollar has been strengthening lately. This is anticipatory of the rate hike, for sure. Yet, looking at the recent rate hikes, both times the dollar was strong in advance, then sold off…a classic, “buy the rumor, sell the news” situation. Viewing the above chart, it shows that as of now, the dollar will be at a lower high than at the time of the December rate hike. This is due to strengthening global economies and the ability of other countries to ease off on their cash printing. So, on this rate increase, I expect the dollar to roll over and trade lower, starting a new downturn in the currency. It’s long overdue and this might be the time.

Looking at the gold market, it has traded in opposition to the dollar for a while. Historically known as a hedge against inflation, I believe at this time gold is simply a hedge against a weak dollar; if the dollar is going down, gold will rally. The above chart is the same USD chart, with a gold overlay. Gold has been strong since the last rate increase, derailed slightly by the increasing likelihood of a March hike. I think gold resumes its march higher when the hike is over, and possibly even before.

But what to do about stocks? We have been cruising along in a bull market. Trumps tweets, interest rate hikes, fears of trade wars, nothing seems to be able to slow this market down. What will happen when the fed raises rates this month? Should investors fear a hike as it will be negative for the market?

JP Morgan’s chart above is a very telling indicator. It gives the correlation between stocks and interest rate moves. What is great about this is that it shows a clear indication that, when rates are below 5%, higher rates is actually good for stocks.

This makes a lot of sense. Really, do investors sell their stocks because they can get a whole .75% risk free return in government debt? I doubt it. I mean, 5% is something meaningful, but rates are still as low as the great depression era and a slight uptick shouldn’t upset any applecarts.

Thus, it appears to us that rates are headed higher and the markets are taking this in stride. The dollar has been a safe haven for a while, and the rest of the world is looking better so it shouldn’t necessarily go higher with rates. Meanwhile gold should be okay, trading opposite to the dollar. And, best of all, stocks look good to continue their surge. At this time, there is no need to fear the Fed.

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