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The Fed Raises Rates...Now What?

The Fed Raises Rates

As we now know, the Federal Open Markets Committee ("the Fed") has decided to raise the federal funds rate to a target of 2% - 2.5%, an increase of 0.25% from the last meeting.  This decision was largely expected and essentially baked into the market.  We are nearly three years into the tightening cycle that the Fed embarked on in January of 2016.  While there have been some bumps in the road along the way, the stock market has seemingly been unfazed by the increases in the federal funds rate for the past 3 years, with the S&P 500 posting double digit gains in 2016 and 2017.

Market Impact

Stocks gave back most of their gains on the day after the 2 PM announcement.  At that time, the Dow Jones Industrial Average, S&P 500 and the NASDAQ were in the green for the day.  By market close, all three major indices posted losses between -0.20% to -0.50%.  What was more surprising was the drop in interest rates all along the yield curve.  The 10 year, which is a benchmark duration for interest rates was off 3-4 basis points (0.0003 - 0.0004) from 3.08% to 3.05% to end the day.  


What Now?

Many financial pundits will likely start talking about the yield curve inverting.  For those that are not familiar with what this is, an inversion of the yield curve happens when short term interest rates, say 2 year bonds, have a higher yield than their longer term counterparts, say 5 year, 10 year or 30 year bonds.  Generally, yield curve compression (10 year rate minus 2 year rate), or outright curve inversion, happen when A) shorter term rates are going up faster than longer term rates, B) longer term rates are falling faster than shorter term rates or C) a combination of short term rates going up while longer term rates are going down.  The Fed has the most influence on the shorter end of the yield curve, while the market generally dictates where longer term rates trade.  Many pundits may argue that "this time is different" (famous last words), but the fact of the matter is that more times than not, a yield curve inversion is generally not a good environment for stocks, especially high beta and growth stocks.  In a strong and healthy economy, an increase in interest rates is warranted, as to not overheat the economy.  However, with growth accelerating for 8 straight quarters, which could be 9 straight once we get the data for the third quarter of 2018, this could be the making of a perfect storm for stocks with GDP growth, earnings and inflation peaking and starting to roll over in the 4th quarter of 2018.