The Fed & market volatility

by: , Economist and Multi-Asset Portfolio Strategist, New York Life Investment Management

On December 19, the US Federal Reserve raised rates by 25bps, setting a new fed funds rate target of 2.25% to 2.50%. Economic projections for 2019 were revised down to 2.3% YOY from 2.5% YOY. Finally, the Fed expects two rate hikes in 2019, on average, compared to the three hikes expected in September’s meeting.

On balance, the announcement was as-expected, if slightly less dovish than investors hoped. The S&P 500 fell by 1.5% and the 10-year treasury yield dipped below 2.8% on the announcement.

Why does it matter?

We expect the Fed to soften its forward guidance early in 2019, hiking rates one more time before slowing its pace. This should be supportive for equity markets. Weaker interest rate expectations in the US should also contribute to a softening US dollar, which would ease pressure on emerging markets currencies and consumers. These dynamics contribute meaningfully to our 2019 call for convergence of US and international markets.

Meanwhile, the Fed has not altered its course of balance sheet normalization. In other words, it will continue to let securities “run off” its balance sheet as they mature. This shift, along with increased issuance of US Treasury bonds to fund the US deficit, should put some upward pressure on yields in 2019. As a result, we see better return prospects from shorter-term debt than large duration positions. Investors benefiting from longer-duration positions should consider active managers with experience in late-cycle environments.

Investors should not be concerned about political influence on the Fed, nor should they be too optimistic that market volatility will materially change the course of monetary policy. The Fed targets two key factors – inflation and employment – when it makes its monetary policy decisions. While it considers data around a variety of topics, such as financial conditions and market volatility, those factors will not drive the Fed’s decisions unless they influence those two key factors.

What’s with all this market volatility?

Uncertainty around the pace of Fed rate hikes is a major contributor to recent market volatility. As economic growth slows, softer-than-expected data releases can cause market angst – even if economic readings are positive. Higher volatility is also often associated with a flattening of the yield curve.

We think recent bearishness on economic growth and company earnings is misplaced. Yes, economic growth in the US and globally is likely to be slower next year. Still, positive GDP growth rates – indeed above trend in many cases – are expected across all major economies in 2019. The economic backdrop for investing is constructive. There are risks, but many of this year’s themes are likely to moderate in the new year.

That said, a soft landing in major economies does not automatically translate to a gentle landing in financial markets. Markets will be watching closely for signs of either a deceleration of economic activity or an acceleration of inflation. We have already seen some early indicators of the former, particularly in rate-sensitive areas. As leading economic indicators gradually soften, investors are more sensitive to noise, feeding elevated volatility.

The cyclical bottom in market volatility occurred in 2017

Volatility index, yield curve slope

Source: New York Life Investments; CBOE; Thompson Reuters Datastream; data as of 12/19/2018. Past performance is no guarantee of future results. It is not possible to invest directly in an index.

 

Past performance is no guarantee of future results, which will vary. All investments are subject to market risk and will fluctuate in value.

This material represents an assessment of the market environment as at a specific date; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

The 10-year Treasury note is a debt obligation issued by the United States government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate once every six months and pays the face value to the holder at maturity.

The S&P 500 Index is widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.

VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking, is calculated from both calls and puts, and is a widely used measure of market risk, often referred to as the “investor fear gauge.”

A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

New York Life Investments is a service mark and name under which New York Life Investment Management LLC does business. New York Life Investments, an indirect subsidiary of New York Life Insurance Company, New York, New York 10010, provides investment advisory products and services. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.

1799663

Lauren Goodwin, CFA

Economist and Multi-Asset Portfolio Strategist, New York Life Investment Management

Lauren Goodwin, CFA is an economist and multi-asset portfolio strategist with New York Life Investment Management’s Strategic Asset Allocation & Solutions (SAS) Group, which has $10B in assets under management. She joined NYLIM in 2018 to focus on global macroeconomic trends

Full Bio

Leave a Reply

Your e-mail address will not be published.