What’s the Fed Going to Do Next? Here’s How to Prepare Whatever Course It Takes

Federal Reserve chair Jerome Powell restated at his most-recent Jackson Hole speech that the Fed will “act as appropriate to sustain the expansion”.

What does that actually mean, though, for interest rates and the stock market? There has been a deluge of punditry trying to dissect and prognosticate just what kind of easing path, if any, the Fed may reembark on. This time last year, the consensus was for at least two rate hikes in 2019; that expectation obviously didn’t age particularly well.

I’m not trying to denigrate reasonable predictions utilizing the best information available, but history and recent events have shown that no one is particularly adept at making these calls. Since we can’t say for certain where rates are headed, let’s prepare for each of the three possible scenarios:

Scenario 1: Continued Dovishness/More Rate Cuts

In a normal world, no one would be discussing this. Powell has correctly articulated the U.S. economy is in a state that essentially meets the Fed’s dual mandate: price stability and full employment. The consumer is strong and U.S. data remains solid, so how did we arrive here?

We live in a bizarre landscape where 43% of bonds not in the U.S. are trading at negative rates, and it’s probable that already anemic global growth will likely take a moderate-to-severe hit from a trade war that has just been ratcheted up a notch. This marks really what is the first time the Fed is nominally not acting in a capacity consistent with its mandate. There is no U.S.-based reason to lower rates.

Yet this is the most likely scenario. If it happens, equities will remain the place to stay. Lower interest rates have been a boon for U.S. markets throughout this expansion, and with a backdrop of real economic strength, the good times should continue. Lower interest rates reduce the cost of capital for companies, making capital investment more likely and fixed income even less appealing than it already is in terms of owning it for the yield.

Back in May, Warren Buffet himself described stocks as “ridiculously cheap if you believe … that 3% on the 30-year bonds makes sense.” Those yields just dropped below 2% this month. Stay in the market if the Fed’s new dovish tilt remains in tact.

Scenario 2: Neutral/Maintain rates

This scenario isn’t markedly different than Scenario 1. Rates are still quite low even left as is (using historical reference points, not contemporary global ones) and this in conjunction with a strong U.S. economy still paints a bullish thesis for U.S. stocks, albeit slightly less so than Scenario 1. In this scenario, it’s more important that the U.S. economy remains growing at a reasonable, roughly 2% pace. If you get this, and rates are left where they are, equities are still the place to be.

Scenario 3: Surprise Hawkishness/An Increase in Rates

Economic analysis aside, the visceral reaction the markets will have to any hint of tightening will not be pretty. Much of the market resiliency in the face of an increasingly strident and aggressive trade war has been due to the assumption of a return to accommodative monetary policy.

To be perfectly candid, if the Fed was actually married to its dual mandate and not what appears to be its new identity as prophylactic soothsayer to the global economy, it should be taking a hawkish tone. But if it were to make a stunning 180 and resume tightening, markets would tremor. Costs of capital would increase, and the U.S. dollar would get stronger than it already is; this is likely the greatest risk of a hawkish Fed.

Our rates are already higher than everyone else’s and we’re as stable and risk-free as you could hope: that’s a recipe for attracting capital. In order to buy our debt, you need to buy U.S. dollars. This would make our currency stronger and put our companies at significant disadvantage, something Trump is aggressively opposed to seeing happen.

If the Fed decides to make a move positively no one sees coming vis à vis tightening, stay on the sidelines.

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