In what will be the final FOMC meeting for Fed Chairman Janet Yellen, the investment world is set for another 0.25 percent rate hike. The current probability based on the pricing of Fed Funds futures is at 90 percent. I would say that is about as certain as you can get. With that level of certainty, that leaves us with two questions: what would happen if the Fed didn’t hike the rate? And what does the market expect going forward?
As for the first question, if for some strange reason the Fed decided not to make the rate hike, it would likely spook the market. While a common mantra for the market is that “the market likes to climb a wall of worry”, the market doesn’t like uncertainty. If for one reason or another the Fed decided to hold off on the widely anticipated move, it would cause uncertainty in the market. Investors would question what the Fed was looking at that kept them from making the move.
One sector that would probably get hit the hardest if the Fed doesn’t raise the rate is the financial sector. Financials have been performing well since the beginning of November and part of that is likely due to the anticipate rate hike. When interest rates move higher, banks benefit as they can charge a higher rate on loans while not raising the rates on their deposit products as much. This improves the margins for banks and thus benefits their bottom line.
Interestingly the industrial sector has also been among the top performing sectors since the beginning of November and that is a sector that doesn’t benefit from higher interest rates. Outside of the financial sector, the industrial sector tends to have higher debt-to-income ratios due to the nature of their business. Financials borrow money in order to lend it back out, so that is a little misleading. Industrial companies borrow for the purpose of building plants, buying equipment and so forth. If the Fed were to postpone the rate hike, the industrial sector would likely jump sharply.
Expectations for 2018
Should the Fed go ahead with the rate hike as anticipated, that leaves us looking ahead to 2018 with a new Fed Chairman. While Jerome Powell isn’t in the chair at the head of the table yet, he appears to hold similar views to those of Yellen. If that is truly the case, the Fed has expressed an interest in making three more rate hikes in 2018. Of course those intentions will depend upon the ever-evolving economic climate. If indicators and reports start to show signs of slowing or if there is some sort of shock to the system, those intentions will go out the window.
Right now, if you look at the way Fed Funds futures are priced, the probability of a rate hike show that traders are looking at March as the next possible hike, but the odds are only a little above 60 percent. The real interesting predictions come in June where the probabilities show a 47 percent chance of the rates being 0.25 percent higher and a 35 percent chance of rates being 0.50 percent higher.
While we have focused on the U.S. central bank, the Federal Reserve, we must also keep in mind that there are a total of 20 central banks that are meeting making rate-setting decisions this week, including the EU central bank and the Bank of England. The busiest day for rate decisions this week is Thursday with 12. Given the number of central bank decisions due out, it could be a volatile week with global financial stocks being the most vulnerable.