The Federal Reserve is on a march – so watch out.
This time last year, traders weren’t expecting the central bank, led by Chair Janet Yellen, to raise interest rates even twice in 2017.
Instead the Fed has already raised its target rate twice to the current range of 1% to 1.25%, and another quarter-point hike Wednesday – at the Fed’s final meeting of the year – is considered a forgone conclusion. While the Fed’s own economists project three quarter-percentage-point increases in 2018, Goldman Sachs Group Inc. (GS – Get Report) and Deutsche Bank AG (DB – Get Report) say four hikes is a likelier scenario.
So with U.S. monetary policymakers now fully immersed in their first major rate-hiking cycle since the mid-2000s, a delicate question confronting analysts is whether the humming U.S. economy and financial markets can hold up. History shows that a steady string of Fed rate increases often end in recession and a big market correction; as Bank of America Corp. economists put it this week in a report, “There is no such thing as a painless Fed hiking cycle.”
The immediate effect will come in the form of higher monthly payments for consumers with credit-card balances, adjustable-rate mortgages and home-equity loans, all of which typically carry variable interest rates, according to Greg McBride, chief financial analyst at Bankrate.com. And that’s to say nothing of corporate borrowers with floating-rate loans.
“It’s like pedaling into a progressively stiffer headwind,” McBride said in an interview. “You’ve got to work harder and harder to pay down the debt.”
This week’s meeting will be Yellen’s last before she turns over leadership of the Fed to Jerome Powell, President Donald Trump’s pick to serve as chair. Yellen is leaving with growth on sound footing, unemployment at a 17-year low and inflation edging toward 2% for the first time since the financial crisis of 2008, seen as a healthy indicator for the economy.
The tax cuts now being pushed through Congress could deliver additional growth that could further strengthen the Fed’s resolve to keep raising rates — to keep the economy from overheating and inflation from spiraling too high.
A gradual pace of rate hikes is warranted, according to Deutsche Bank, given the “labor market at full employment, record easy financial conditions, rising odds of fiscal stimulus and early evidence that inflation is recovering.”
But it might not work out that way. The odds have risen that the Fed, which is supposed to maximize employment while keeping prices stable — could need to hike more aggressively, Deutsche Bank economists wrote in a Dec. 8 report.
That could bring pain for investors, who have benefited from this year’s 19% rally in the Standard & Poor’s 500 Index, though at the cost of an increasingly expensive market. Goldman Sachs warned investors last week that stocks and bonds are trading at the highest average valuations since 1900. Yields on fixed-income securities are still so low – the 10-year Treasury yield is at 2.38% — that many investors are taking on increasing risks in search of bigger returns.
The frenzy in bitcoin, where prices have climbed 17-fold this year to a record $16.356 as of Tuesday, serves as a reminder of just how wacky financial markets have become.
While stock markets may have further room to run in early 2018, a big correction could come by the middle of the year, according to Bank of America.
“The Fed needs to be prudent in monitoring risks and to heed caution as rates approach long-run equilibrium,” the bank’s economists wrote.