by Denise Chisholm, Director of Quantitative Market Strategy, Fidelity Investments
Investors have spent the better part of the last few months arguing over the same question: will the Fed hike or won't they? Judging by market reaction to every speech, data release, and offhand comment from a Fed official, you might think the answer is critically important to equities. History suggests otherwise. The reason is simple: whether a rate hike is good or bad depends almost entirely on where rates are starting from. If the policy rate were 2%, investors would already be expecting tighter policy. If the policy rate were 6%, they'd be debating when the cuts begin. The action itself matters less than the starting point. That’s why it helps to step back from the meeting-by-meeting speculation and ask a different question: where should rates be?
So let's pick up where we left off last week. Like long-term interest rates, short-term rates have maintained a fairly stable relationship with nominal GDP growth over time. The relationship isn't perfect, but it suggests the same conclusion we reached in last week's note on the 10-year Treasury. Today's policy rate appears somewhat low relative to current growth conditions. Assuming nominal GDP remains near recent levels, which have been driven in no small part by the recent pickup in inflation, the historical relationship would be more consistent with roughly another 75-90 basis points of tightening. If that sounds bearish for stocks, the historical evidence suggests investors should be careful. The surprising part of this analysis is not what it says about the Fed. It's what it says about equities. Across much of the historical distribution, equity returns have looked remarkably similar whether rates were modestly above or below where growth might have implied. The relationship only becomes particularly important at the extremes. When policy falls dramatically behind economic growth, market outcomes deteriorate meaningfully. But from today's starting point, we are nowhere near those levels.
That doesn't make the relationship unimportant. In fact, its real value may be explaining the market's current confusion. Historically, the further rates fall behind nominal growth, the greater the odds of additional tightening. Our current position in the distribution implies roughly a 53% probability of a hike, which sounds suspiciously like the debate currently taking place in markets. If investors feel like they're getting whipsawed between hike and no hike, it's because the data are effectively saying the same thing. But that's also why the debate may be missing the bigger picture. The signal isn't really in the ‘whether’. It's in the ‘how much’.
Historically, the biggest market problems have emerged when the Fed finds itself significantly behind the curve and is forced into an aggressive tightening cycle. Modest tightening, by contrast, has usually been manageable. Sometimes that's because growth is strong enough to offset the impact (hello payroll report). Sometimes it's because higher rates are a reflection of stronger growth in the first place. And sometimes it's because the market has already done what markets do best: discount the news long before it arrives. After all, markets have a habit of discounting bad news before it becomes news, frustrating the maximum number of investors possible. Viewed through that lens, another 75-90 basis points of tightening delivered over the next year looks far less ominous than investors might assume. The real risk has never been the first hike. It's when the Fed finds itself needing a lot more than one. As the old saying goes, it isn't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. If history is any guide, the belief that modest Fed tightening must be bad for stocks may be one of those things.
This information is provided for educational purposes only and is not a recommendation or an offer or solicitation to buy or sell any security or for any investment advisory service. The views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. Opinions discussed are those of the individual contributor, are subject to change, and do not necessarily represent the views of Fidelity. Fidelity does not assume any duty to update any of the information.
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