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Don't Fear the Coming Interest Rate Hike
The "Street" is so worked up about it that the relief when the Fed finally moves will be palpable -- and a rally is likely

This article is from a US perspective, nevertheless, interesting opinions

You have to give the Federal Reserve credit for making its intentions clear. Investors are all but agreed that the rate-setting Federal Open Market Committee (FOMC) will raise rates 25 basis points, or a quarter of a percentage point, at its June 30 policy meeting. After that, the committee is expected to raise rates by 25 basis points another three or four times this year, as necessary to restrain budding signs of inflation. "They've gone out of their way to signal what they intend to do," says Robert Smith, president of bond investment firm Smith Affiliated Capital.

As evidence of the leisurely pace of future rate hikes, Fed watchers point to the addition -- in the statement released after the May 4 meeting -- of the word "measured," describing its policy-making approach. More recently, in a May 18 speech, Richmond Federal Reserve Bank President Alfred Broaddus acknowledged investors' expectations of a period of tightening and explained why he's not yet worried about inflation.

Another clue: On May 20, Fed Governor Ben Bernanke is scheduled to give a speech titled, "Gradualism." That word "implies a whole bunch of quarter-point moves," explains Trip Jones, managing director of sales at SunGard Institutional Brokerage.

PRICED IN.

These obvious signals from the Fed and the relative consensus among investors about its intentions is a positive for today's embattled stock market. As long as the Fed sticks to its plan, it's looking increasingly like the much-feared first rate hike -- once it arrives -- could actually kick off a stock-market rally.

Wouldn't that be a fine how-do-you-do? For the past three months, the market has drifted lower as worries about the impact of higher interest rates combined with an escalation in geopolitical turmoil to trump strong economic news and gangbuster earnings growth.

Now, worries about higher rates have been priced into both the stock and the bond markets (futures markets anticipate the Fed will hike rates four times this year), creating the potential for a run-up in securities prices when the move actually happens.

MEASURED PACE. Some think even more than 25 basis points would be good for the market. "I'm of the view that if the Fed tightened more, it might actually be better," says Jason Trennert, chief investment strategist at International Strategy & Investment (ISI) in New York. He thinks it would signal greater confidence in the strength of the underlying economy. Plus, by acting quickly, the Fed "might allay some of the fears about how aggressive it might have to be," Trennert adds. He admits, however, that a half-point hike "is very unlikely."

The first increase will be reassuring to investors on two levels. For one thing, a 25 basis-point move would prove that the Fed is following through on its plan for "measured" tightening and doesn't intend to make any jarring changes, like the series of aggressive hikes in 1994 that wreaked havoc on bonds. "The market here is looking for consistency in its message," says Peter Coolidge, a portfolio manager at Deltec Asset Management in New York.

History shows that the market almost always rallies after the first in a series of rate hikes, says Trennert. "The only instance where that wasn't the case right away was in 1994, when the first Fed tightening was a surprise," he says.

RETURN OF THE HAWK. The second reassuring thing about a rate hike would be to prove that the Fed hasn't become too complacent about the potential for inflation. Investors have lately grown concerned -- not about the current level of inflation, but about how fast it has climbed off the bottom.

During 2003, inflation in core personal consumption expenditures (PCE) rose just 0.8%, Broaddus explained in his May 18 speech. But in the 12 months ended March, 2004, the rate climbed to 1.5%. That upswing "has naturally gotten the attention of all of us who are determined to contain inflation," he said. "I'm dusting off my old inflation-hawk feathers in case I have to flap my wings one more time before I leave the Fed." The message to investors: Don't worry about inflation, the Fed is on the case.

When June 30 arrives, the market's reaction to news of a hike will depend in good part on how the economy performs in May (it seems to be cooling a bit from April), as well as how the Fed words its statement. "A rate hike is baked into the cake," says Coolidge. "What's still unanswerable is the language they will use to convey it."

If the economy shows signs of mellowing in the next month, additional rate hikes forecast by the futures markets may not prove necessary. "A lot of things have self-corrected," says Smith. Soaring commodity prices have come down (except for oil), and the consumer spending is showing signs of slowing a bit as long-term interest rates and mortgage rates rise. And the Chinese government is trying to modulate down its rip-roaring economy.

PARTY TIME? Also, corporate profit growth will slow in the third and fourth quarters, as comparisons with last year become tougher. Job growth is improving, but still not booming. Strong productivity growth will restrain the need for companies to add workers to meet demand. And capacity utilization has improved, but remains below levels that normally would lead to supply constraints.

All told, many economists believe investors' fears of inflation are overblown. "We'll get a rally if people think the Fed would be loath to do another one very quickly," says Smith.

The Fed meeting is still six weeks away, and the economic and market outlook could change dramatically by then. If the economy is booming, stocks could falter, since investors would worry that more and steeper rate hikes are needed to stall inflation. "If growth remains strong and the acceleration in core inflation numbers continues, [the Fed is] going to have to pick things up a little more quickly," says Joel Naroff, president of Naroff Economic Advisors in Holland, Pa. That could spark more selling.

But as signs accumulate that the economy is slowing a bit on its own, it's looking increasingly likely that the first rate rise may be a market event to celebrate, rather than fear.

 

 

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