Fed Rate Hikes - Mixed Action On Friday

Before delving into Fed rate hikes, let's review Friday's market action. With all the volatility in the past few weeks, it appears investors aren’t focused on the midterm elections.

At worst, I think the election won’t affect stocks. At best, it will inspire a big rally. Stocks were mostly down on Friday. That was because of the high wage growth in the BLS report. It was also because of Apple’s weak earnings, not the election.

The S&P 500 fell 0.63% and the Nasdaq fell 1.04%. Apple dragged both indexes lower as it fell 6.63%. The Russell 2000 was up 0.19%.

This potentially shows what the market could have looked like without Apple. Since I think wage growth was also a negative, gains would have been amazing. The CNN Fear and Greed index is still in the single digits. It increased from 6 to 8 which signals extreme fear. I’m very bullish on stocks in the short run.

The other major news was on tariffs. There were swings in the headlines. At first President Trump claimed America and China are close to a deal. Then Trump’s top economic advisor, Larry Kudlow stated, “There’s no massive movement to deal with China. We have already put out asks China with respect to trade”.

Politics could be playing a role in the statements on trade. This administration wants to assure the public that things are going well with negotiations right before the election. If investors really believed a deal was imminent, the stock market would spike over 3%.

The worst sectors were technology and real estate. Apple missed earnings and the wage growth report causes treasury yields to spike. The tech sector was down 1.89% and the real estate sector was down 0.93%.

Two positive sectors were the financials which increased 1 basis point. And the other was consumer discretionary which was up 0.41%. Strong wage growth is great for consumers. Accelerating wage growth and stable inflation is a recipe for sharp real wage growth.

Fed Rate Hikes - Big Selloff In Treasuries

Any beat on wage growth would mean stocks and bonds would fall. The bond market fell sharply on Friday. 10-year yield increased 8 basis points to 3.21%. 2-year yield increased 6 basis points to 2.9%.

This means the difference between the 2 yields is 31 basis points. On Friday, the financials liked rising rates and a steepening yield curve. However, sometimes investors in the financials are fearful of rising rates. It means demand for mortgages will fall.

By hitting 2.92% during the day, the 2-year yield hit a new cycle high. The 10-year yield is still a few basis points away from its recent high of 3.26%. Today was a big day for the bulls who don’t fear slowing growth.

Fed Rate Hikes - 1 Hike In 2018 & 2 Hikes In 2019

Since the 2-year yield increased to a new cycle high, it’s no surprise the chance of a rate hike in December increased. There is a 79.2% chance of at least one more rate hike this year.

The odds for December 2019 are now out. There is a wide range of expectations. The most likely scenario is 1 hike in 2018 and 2 hikes in 2019.

There is a 59.7% chance there will be 3 more hikes by December 2019. 4 more hikes will push the current Fed funds rate above the long run expected rate.

However, the long run rate could increase along with the Fed funds rate in the next year. The Fed funds rate is very close to the neutral rate. I think rates will be contractionary after the hike in December.

Fed Rate Hikes - Q4 GDP Expectations

Personally, I will be putting the economy on recession watch in the 2nd half of 2019. Global growth is slowing, tariffs are hurting growth. Also, the Fed is about to hike rates above the neutral rate.

The Q4 GDP report should be solid, but growth should slow from Q3 because the fiscal stimulus is wearing off. Expectations from the regional Fed GDP Nowcasts are solid.

As you can see from the table below, the average has increased from 2.58% to 2.82% from October 26th to November 2nd.

On Friday, the Atlanta Fed Nowcast fell from 3% to 2.9%. The estimate for real non-residential equipment investment growth fell from 11.8% to 10.9%.

That’s still a very optimistic estimate. The estimate for government spending growth fell from 2.4% to 2.2%. If growth falls that much, it means the fiscal stimulus is wearing off.

Inventory investment is expected to hurt GDP by 5 basis points instead of 1 basis point. I expect exports will be stronger in Q4 than Q3 and inventories will help growth by less.

The NY Fed Nowcast estimate increased from 2.55% to 2.61%. The 2 biggest positives came from the ISM prices index and the ADP report. The CNBC rapid update shows an average of 6 estimates pin GDP growth at 3.6%. That’s hotter than all the Nowcasts.

Fed Rate Hikes - Returns Before Recessions

Personally, I think a recession in 2019 is very unlikely. However, I will go on recession watch in about 8 months. Stocks tend to react to recessions before they occur.

As you can see from the chart below, from 12 months to 6 months prior to recessions, the median reaction stocks have is a 1% decline. The worst returns are from 6 months prior to the recession to the start of the recession. The median decline is 5.5%. Since I expect a recession in 2020, 6 months prior could include 2019. That’s why I think next year will be volatile.

(Click on image to enlarge)

Fed Rate Hikes - Conclusion

The too early projection for Q4 GDP growth is somewhere between 2.6% and 3.6%. That means growth will slow again, but there is no chance of negative growth.

The consumer will be in great shape because wages will be strong. However, the Fed will begin to tap the breaks on this expansion. This will become the longest since the 1800s in 8 months.