It’s a foregone conclusion in the markets that the Federal Reserve will raise short term interest rates on Wednesday. But more importantly, investors will be looking for hints for future rate increases.
Why is this so important? The consensus view is for 2-3 Fed increases this year, but anchoring into this expectation comes with risks. For example, in 1994 the Fed surprised investors by increasing rates 6 times, resulting in a 3% loss for bonds that year. Of course, bonds recovered in following years, thanks largely to the long-term trend of falling interest rates since 1981.
“People only see what they are prepared to see.”
-Ralph Waldo Emerson
On Thursday, investors will get a first look at Q1 GDP that is unlikely to impress. According to Bloomberg, economists expect Q1 economic growth of just 0.6%, and it’s possible we could even see a negative number. However, the intelligent investor won’t overreact, especially given the recent issues in reporting Q1 GDP data.
We first wrote about the anomaly in Q1 GDP data back in July 2015. Simply put, research from the Federal Reserve seems to indicate persistent errors in first quarter GDP reporting. According to a study by CNBC that looked back to 1990, these errors average out to GDP revisions as large as 1.3%. In other words, a 2.0% GDP figure could ultimately be revised to anywhere from 0.7% to 3.3%. Even the Bureau of Economic Analysis, the government body in charge of GDP data, acknowledges issues.
Yesterday the Fed, led by Janet Yellen, made the announcement the investment community has been expecting: A 25 basis point increase in the Federal Funds rate. The Fed voted unanimously to set the new Federal Funds rate to .25%, up from zero. The outlined path will be a gradual increase with a target rate of 1.38% by the end of 2016. Improvements in the job markets and an increasing level of inflation both supported the Feds decision to increase rates.
The increase draws a close to an unprecedented period of low rates that were part of a grandiose plan implemented by the Fed to help stimulate the economy after the turmoil in 2008. The financial markets took the rate increase announcement in stride, reflecting growing conviction among investors that the U.S. is strong enough to withstand higher borrowing costs.
All eyes are on the Fed this week.
What this means is that when the Fed and Central Banks are accommodative to growth…like they have been for a long time…we take other indicators, such as fundamental market valuation indicators, and give them a bit less weighting in our overall assessment of investment opportunities and dangers. Simply put, fighting the Fed or “tape” is typically considered foolish in the world of investing.
Our research indicates that regardless of when the Fed starts increasing rates from the current emergency level, that the increase amount and pace will be low and slow. Here’s a brief snapshot of some reasons why:
For example, take economists’ forecasts. According to Ned Davis Research Group, economic forecasters have not correctly predicted any of the 7 recessions experienced since 1970. In fact, the forecasters as a group have never even called for a recession.