Strengthening economic headwinds have weighed on investors recently, especially as Federal Reserve (Fed) policymakers ramp up rhetoric on the future path of interest rates.
As shown in LPL’s Chart of the Day, market expectations for rate hikes dropped significantly last month. Fed fund futures are now pricing in an upper-bound fed funds rate of 2.7% for the end of 2019, even while pricing in an 80% probability of a rate hike at the December meeting.
Short-term breakeven rates, or the difference between the yields of nominal Treasuries and those of Treasury Inflation-Protected Securities, have dropped to multi-year lows, corroborating the view that downside risks may weigh on output.
Until recently, investors had been bombarded with negative headlines about trade, geopolitical issues, and deteriorating economic data globally. Because of this, the Fed’s comments on the neutral rate—the point where monetary policy is neither accommodative nor restrictive to the economy—have played a larger role in the path of financial markets.
“Investors have been understandably anxious about any mentions of future policy, especially as headwinds have strengthened in recent weeks,” said LPL Chief Investment Strategist John Lynch. “However, we encourage investors to have faith in the Fed’s strategy of viewing monetary policy as a shifting target that is constantly re-evaluated amid economic developments and incoming data.”
In October, Fed Chair Jerome Powell mentioned that interest rates are “a long way from neutral,” sending the 10-year Treasury yield to a 7-year high and fueling an eventual correction in the S&P 500 Index. Last week, Powell effectively walked back these comments in a speech, and Fed Vice Chair Richard Clarida classified current rates as “much closer” to the neutral rate. Powell’s and Clarida’s comments sparked the S&P 500’s biggest weekly rally in five years.
We encourage investors to be patient with the Fed’s cautious approach to decision-making. Policymakers’ strategy of evaluating upside and downside risks should decrease the chances of a policy mistake as the Fed attempts to balance its dual mandate of full employment and low and stable inflation.
For more of our thoughts on the Fed’s recent comments, check out this week’s Weekly Economic Commentary: Fed Shows Flexibility.
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