Investors Sound Warning About Markets’ Complacency on Interest Rates
Financial markets have rallied since the Fed dropped a reference to future rate increases; ‘it seems frankly optimistic to expect nothing from the Fed in the next 12 months’
By Akane Otani
Some investors are concerned that the assumption underpinning markets’ rally—that the Federal Reserve has stopped raising rates—could be wrong. The floor of the New York Stock Exchange. Photo: Michael Nagle/Bloomberg News
Stocks and bonds are rising on bets that the Federal Reserve has ended its nearly four-year campaign of interest-rate increases, worrying investors who believe the central bank could upend those expectations later this year.
Since the Fed’s January meeting, a number of investors and traders have concluded that the central bank hasn’t just paused its rate increases, but finished them altogether.
Some believe the Fed’s next move could be to cut the benchmark short-term rate, something it hasn’t done since December 2008, when the global financial crisis forced the central bank to slash rates to near zero.
The shift is unsettling some investors who believe that much of this year’s rebound across stocks and bonds has been fueled by bets that the Fed won’t raise rates again in the foreseeable future. Loretta Mester, president of the Federal Reserve Bank of Cleveland, said Tuesday that interest rates should rise slightly this year assuming the economy grows at the pace that she expects. Money managers will get another look at the Fed’s view on interest rates and the economy on Wednesday, when the central bank is scheduled to release minutes from its January meeting.
The S&P 500 and Dow Jones Industrial Average have extended gains since closing out their best January in decades, with both indexes up around 10% in 2019 and at their highs for the year. Meanwhile, the yield on the two-year Treasury note—which tends to move in tandem with rate expectations—has fallen for three consecutive months, its longest such streak since 2013, according to Dow Jones Market Data. Yields fall as bond prices rise.
“It seems frankly optimistic to expect nothing from the Fed in the next 12 months,” said Isabelle Mateos y Lago, managing director and chief multiasset strategist at BlackRock. “When you look at payroll data, this is not an economy that’s about to be in recession.”
Much of the disagreement over the Fed’s next rate move stems from its decision in January to remove explicit reference to future rate increases from its monetary-policy statement. Before the January meeting, the central bank had included that language in all of its statements since 2015.
The removal, coupled with Fed Chairman Jerome Powell’s comment that “the case for raising rates has weakened somewhat,” helped send the Dow industrials soaring 435 points, or 1.8%, on Jan. 30. Now, federal-funds futures—used by traders to place bets on the course of monetary policy—show the market pricing in a 0.9% chance of the Fed raising rates at least once by year-end, down from about 30% a month ago, according to CME Group.
Gautam Khanna, a fixed-income portfolio manager at Insight Investment, said he has been increasing the share of rate-sensitive securities such as Treasurys and mortgage-backed securities in his portfolios since the end of last year. That is a response to slowing global growth and growing evidence that the Fed is done raising rates, he said.
There are “too many risks out there,” Mr. Khanna said. “The lion’s share of what the Fed is likely to do this cycle is already behind us.”
Yet a number of fixed-income analysts say the Fed doesn’t appear to have ruled out future rate increases. Instead, they say, the central bank merely indicated that it is on pause for now.
“The communication shift basically went from explicitly saying further rate hikes are warranted to them saying, ‘I don’t know.’ And just saying, ‘I don’t know,’ doesn’t mean there are no more rate hikes coming,” said Jon Hill, vice president and interest-rate strategist at BMO Capital Markets.
One reason some analysts remain skeptical the Fed is done with rate increases: The economy, they say, looks far stronger than it did the last time the Fed decided to lower interest rates.
The U.S. labor market has added jobs for 100 consecutive months, the longest such streak in history. While inflation pressures remained stubbornly muted for much of the past decade, giving the Fed few reasons to accelerate its pace of rate increases, the tight labor market appears to have finally started to translate into a pickup in wages. The Labor Department’s January jobs report showed wages rose at least 3% on a year-over-year basis for the sixth consecutive month, building on what has been the biggest uptick in pay since the end of the recession in 2009.
“Some of the market having a high conviction that the next move is a cut fails to recognize just how tight the labor market is and the fact that growth continues to persist above trend,” Mr. Hill said.
Some pockets of the economy are starting to show signs of weakness. Data point to a cool-down in the housing sector. The Conference Board’s widely watched measure of consumer confidence has fallen for three consecutive months, while a report Thursday showed retail sales fell in December at the fastest pace since 2009.
Then there are variables like the U.S. and China’s trade conflict that stand to exacerbate a slowdown in economic momentum around the world.
“China is probably going to get worse before it gets better, and the U.S. will feel that slowdown,” said Andrea Cicione, head of macro strategy at TS Lombard, who believes the Fed is likely to lower rates by the end of the year.
Still, data on the whole point to an economy that is cooling—not sharply deteriorating. That leaves market bets, particularly for stocks and shorter-duration Treasurys, vulnerable to a reversal, analysts say.
“You don’t necessarily want to assume anything in either direction,” Mr. Hill said.
—Sam Goldfarb contributed to this article.
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