Rising To The Occasion?

The week of the Fed decision has arrived, with all eyes set on Janet Yellen’s press conference Thursday. Wall Street – and global streets – await with bated breath and anxiety, if it wasn’t already apparent given the volatility in stocks over the past few weeks.  If you’re unsure of whether rates will rise, you’re not alone – the market is wondering the same thing.

The numbers speak for themselves. 46% of institutional economists expect a raise this week, per the WSJ – so opinions are torn. Traders, meanwhile, think there is a 26% probability, based on CME Fed fund futures – a number half of what it was a month ago. Several banks are ‘Septemberists’, while many, including Goldman Sachs, are ‘Decemberists’ – and others, such as Deutche Bank, are adding some spice by introducing an October hike potential. Many institutional investors, including Bridgewater’s Ray Dalio,  are talking about the opposite extreme – another round of easing, or no hike until 2017, per Komal Sri-Kumar. Note that the XLF financials ETF – expected to benefit with higher rates, was up over 2% through mid-August; it’s now -6.5% YTD. The wide range of opinions and uncertainty highlights the incredibly complex global picture the Fed is dissecting.

Does the Fed have reasons for delaying? Sure. Unlike past rising rate environments, there is no economic indication of overheating, inflation concern, evident sector bubbles, visible overleverage, commodity spikes, or wage pressure. Alongside, the entire planet’s financials are looking shaky, with Citigroup’s economics team even predicting a 55% chance of a recession in the next two years. If US rates rose, additional currency turmoil with debt obligations could push numerous nations, including Brazil and Turkey, to the edge of default. China’s summer market crash, the corresponding emerging market capital flight, the collapse in oil over the past year followed by numerous other commodities, and diametrically opposite monetary policies in Europe and Japan all point towards a rate hike being the last thing the world needs today from the largest, most influential economy.

The logic for raising? Near-zero rates are meant for emergencies, and have not budged since 6+ years; after first being implemented during the 2008 recession, they still remain at the same levels while equity markets have more than tripled, the US unemployment rate has halved, and the economy has, without a doubt, shown improvement. Keeping them at zero also depletes the Fed of ammunition in case the economy goes downhill again. The US, after all, must fend for itself – and given the U6 employment statistics, regional wage pressures, growth rates and signs all pointing towards a tightening labor market, the Fed  must look to fulfill the mandate it was designed to, with US employment and inflation at the forefront of its decisions. Overseas turmoil would have limited impact, considering exports form barely 14% of US GDP (World Bank data), and small businesses employ nearly 90% of the population (SBA data) – with a majority of their revenues being domestic.  Consumption is strong, and housing is on the mend. Retirees and pension plans have suffered in the current environment; riskier assets, such as equities, meanwhile, have prospered – helping the top 10% of the population that own over 80% of stocks outstanding, according to a study in 2010 by NYU’s Edward Wolff. An interest rate normalization would help level the playing field. It’s about time, and has been for months, according to several noted names on Wall Street.

Of course, it would be foolish to disregard international opinions. The IMF and World Bank have repeatedly warned against raising rates and destabilizing the world economy, as have several other finance thought leaders, including Indian Reserve Bank governor Raghuram Rajan. At the same time, numerous finance ministers have countered, asking the Fed to hike and rip the bandaid off – in effect, remove uncertainty, so companies, investors, and nations can get on with life. The bottomline? Buying or selling stocks by trying to predict the outcome of the meeting isn’t our best bet, given the market itself remains unsure of the decision, which is why the volatility persists. If you’re a long-term investor, use the time to scoop up bargains based on fundamentals. In the long run, 25 basis points is a drop in the bucket. If a hike occurs, rest assured that the highly accommodate Fed’s decision means the US economy is in much more robust shape than investors thought; any moves lower would just provide greater discounts. The quality of the business doesn’t change overnight, after all.

What it means for you: The uncertainty and divided opinions are heavy in the air. While many attributed the market’s summer downturn to China, the lack of significant change in treasuries, with the 10-year yield barely moving YTD, non-existence of bids for the ultimate safety play – gold (-6.5% YTD), and defensive sector underperformance, including utilities (-12.8% YTD) suggests interest rate uncertainty had a massive role in the action. This week, expect the volatility to continue until Thursday afternoon as the Fed decision takes over the media and investor attention. Keep cash handy, along with some popcorn – it promises to be an exciting week ahead on Wall Street.

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