Is 8th rate hike the limit for stock market?
Could eight be the new three? The old Wall Street yarn about stock prices hitting the floor after the Federal Reserve raises interest rates for a third time was initially formulated by market technician Edson Gould and later rebranded “three steps and a stumble” by investment adviser Martin Zweig. Though the formula has a wildly uneven track record — hitting the mark in the 1970s and early 1980s and mostly missing thereafter — it nonetheless reflects the importance of low borrowing costs to keeping stock prices upright.
Since the Fed’s third rate hike in March 2017, when benchmark rates were at only 1 percent, stocks are up another 14 percent. But nine years into the second-longest run of uninterrupted growth on record, the U.S. now has entered that seemingly contradictory stage of the business cycle where good economic news is not necessarily good news for stocks and bonds.
By itself, the selloff that began in early October wasn’t unusual or unexpected. Over the last century, stocks have dropped by between 10 percent and 20 percent — the common definition of a market correction — an average of about once a year.
Following a pain-free 2017, stocks have fallen by at least 10 percent twice in 2018. Embedded in the negative numbers are several troubling signs.
Small-cap stocks — historically a leading indicator of the economy and thought to be less exposed to a trade war — were under-performing. The number of stocks trading below their 200-day moving average slipped above 50 percent. Market-leading technology stocks were falling hardest and fastest.
The trigger for the volatility could be traced to worries over interest rates. Since August, the yield on the Treasury’s 10-year note has climbed by a half percentage point as growth has powered ahead and the Fed reiterated plans to normalize monetary policy to headoff inflation.
Sitting in neutral
At 2.2 percent, the benchmark interest rate set by the Fed at its September policy meeting exactly matches core inflation, implying that the price of money neither stimulates not restrains economic growth. But with the economy surging and resource markets tightening in the wake of last year’s tax cuts, monetary policy might still be too loose despite eight quarter-point rate hikes since December 2015.
Over the past 60 years, the base cost of credit set by the Fed has averaged 1.28 percentage points above core consumer inflation. But excluding the extraordinary measures taken to resuscitate the U.S. economy in the aftermath of the financial crisis, the number climbs to 1.84 percentage points, which, if applied to current inflation, would put benchmark interest rates near 4 percent, or close to double the current level.
As it turns out, that number is near where some members of the Fed’s ratesetting committee — but until recently, not many investors — see rates going over the next 18 months.
Not surprisingly, the rate hikes have not been well received at 1600 Pennsylvania Ave. In an unusually personal attack on Fed leadership last month, President Donald Trump claimed that monetary policymakers were “going loco” and that Chairman Jerome Powell “almost looks like he’s happy raising interest rates.”
Though some presidents have tried to influence monetary policy, such overtures generally were made behind closed doors and with recording devices turned off. That might explain why, with an election approaching in the summer of 1984, Fed Chairman Paul Volcker was asked to meet President Ronald Reagan and Chief of Staff James Baker in the White House library rather than in the Oval Office. The library location, Volcker speculates in a recent memoir, “Keeping at It,” was chosen for its apparent lack of a taping system.
And for good reason.
“The president is ordering you not to raise interest rates before the election,” Volcker recalls Baker as telling him, as a clearly uncomfortable Reagan sat silently nearby. Volcker, who had no plans to raise rates anyway, walked out of the room without saying a word.
Based on the Fed’s latest projections, benchmark rates will top out at about 3.6 percent in 2020, assuming inflation doesn’t accelerate. Before rates get anywhere close to that level, expect a meeting between Trump and Powell.
It’s a good bet it won’t be in the library, and that the president won’t be silent.
Tom Saler is an author and freelance financial journalist in Madison. He can be reached at tomsaler.com.