Yesterday, the Federal Reserve completed it’s about face by deciding to abandon its plan for gradual interest rate increases. A recently as the 4thquarter of last year, the Fed had plans to raise rates as many as four times this year. The stock market welcomed the announcement from the Fed with the Dow rising as much as 500 points intra-day. Should we really consider this a positive?
Looking back at history, the Fed has pauses their interest rate increases during every business cycle. Unfortunately, many of the pauses were shortly followed by recessions. The chart below shows the Fed Funds rate going back to 1955. Over that time, the Fed has stopped raising interest rates 13 times. The red circles on the chart (nine total) are pauses that were shortly followed by a recession, while the green circles (four) indicate no recession.
History would suggest that if the Fed stops raising rates, that’s not necessarily a good thing. It is however, certainly better than the alternative, further rate increases. With the Fed on hold, it should be considered a positive sign for further economic growth. That is, at least in part, the reason the stock market rallied so much yesterday (Apple’s strong earnings were lifting markets before the Fed announcement).
Unfortunately, the bond market might be sending a different signal. If the Fed holding tight on raising rates is good for the economy, you would expect long-term interest rates to rise. The logic being – better economic growth leads to higher inflation, which is bad for bonds, resulting in higher yields. The bond market however, did the opposite – yields fell. The bond market may be pricing in the idea that the Fed has already raised rates too far for this cycle. In fact, futures markets are suggesting that rate cuts are more likely than hikes over the next 12 months (see table below).
While we welcome the pop our equity positions experienced yesterday, the Fed pause doesn’t suggest it will be smooth sailing indefinitely. This happens during every business cycle. The yield curve is still very flat, with parts of the curve inverted. The big question now is whether or not economic growth, which has been slowing, continues to decelerate. We will be keeping a close eye on our Business Cycle Index for clues as to whether this is a mid-cycle pause, or the end of the cycle. Both include the actions the Fed took yesterday.