Fed Hikes Rates (as expected) – Delayed Reaction

On September 26, the Federal Reserve followed through on its plans to continue gradually raising interest rates, moving the federal funds rate up by 0.25% to the range of 2%-2.25%.  This is now its eighth hike since it began “normalizing” policy in December 2015. They projected that they will raise them one more time this year. 

Initially, the reactions in the markets were muted with U.S. stocks continuing to dramatically outperform the rest of the world and trade near record highs on the back of a firm dollar.  Also, the bond market at first reacted calmly with virtually no change in the longer-term, 10-year treasury rates at a bit over 3%.  However, as I write this commentary, the bond market has begun to sell off sharply with 10-year treasuries now pushing to 3.25% in a very quick move higher (yields).  At the same time, stock markets around the world have begun to experience bouts of selling and even bigger moves. 

Competition for Investment Dollars.  I mention this because for the first time since the financial crisis a decade ago, investors are beginning to receive measurable, though still low, income by investing in the safer fixed income holdings such as CDs, treasury securities, municipal bonds and even money market funds.  We are seeing a great reversal of the Fed policy initiated a decade ago.  At that time, the Fed lowered interest rates to zero to induce investors to take on more risk by investing in lower quality bonds, high-dividend stocks, and eventually stocks in general.  The strategy was designed to combat the panic that had set in to markets.  As we know now, their strategy was successful.  Now, as they ratchet rates up, savers are beginning to find bonds with low but positive returns and relatively low volatility to be competitive to stocks with potentially higher returns but potentially much higher volatility (read: possibility of sizable losses).   Stock prices also, of course, reflect their companies’ profitability which can be negatively affected by rising borrowing costs, especially at a time when much of corporate America has taken advantage of previously lower rates to leverage their balance sheets.

As I’ve mentioned in previous commentary, there continues to be a huge divergence between the performance of U.S. stocks and stocks in most other markets around the world.  Last month, the Pacific region (especially Japan) showed some strength.  However, the bulk of non-U.S. markets continue to roll lower.  The divergence has been stunning with the correlation between international/emerging markets with the U.S. market having gone from having a positive 90% correlation these last three years to a negative 60% correlation!  This is an amazing change, especially on the heels of last year’s synchronized economic growth.

We continue to watch to see if the non-U.S. markets can turn around and join the advance to continue this long-running bull market or if the U.S. markets will eventually roll over into a long overdue correction or even bear market.  The important thing is to be emotionally and structurally prepared for the possibility of sharp selling with the hope that it does not materialize for a while longer.