Yesterday, the Fed announced the expected 25 basis points rate hike of the night after a reaction which has thus far resulted in a 109-Pip decline. The stock market was consistently negative, declining by a maximum of about 3.8%.
While some of the stock market reaction can be justified, given that rate hikes are usually negative for the overall economy, the extent of the movement, which appears to be the worst since 1994, as well as the delayed negative reaction by the Dollar appear rather inexplicable, if we just boil it down to the economics of the country. However, the devil is in the details, and more specifically in the FOMC communication.
In particular, the FOMC decided to reduce the number of rate hikes to two in 2019 (as we suggested in this post yesterday), down from three in the previous communication. This suggests that the economy would most likely grow faster than in the three-hike scenario, given that the average interest rate during 2019 would be lower. As suggested in earlier posts, lower interest rates compared to the previous scenario should boost stock markets and push the currency lower. In this case, the switch from the three-rate hike to the two-rate hike suggests that the interest differential in 2019 would be lower than expected and hence the Dollar should decrease.
The natural question in this case would be why the stock market reacted so negatively, especially given that the two-hike scenario would be more positive for the economy compared to the three-rate one. The justification is simple: the reduction in the number of rate hikes implies that the economy is not really as strong as expected and growth is not as robust as investors originally thought. In essence, the reduction in the number of rate hikes more or less confirms the fears investors have had regarding the US economy, over the past months; if the Fed is backing down, then the outlook must be worse than expected.
What does a worsening of the outlook mean? Naturally, lower profitability for firms, resulting in lower valuations and hence stock market declines, something we have been experiencing since October. Fiscal deficit/debt and trade tensions are the major causes of worry and still loom in the US economy, as articulated in our October analysis. The fact that the US is a net importer also implies that a slowdown would be transmitted in the rest of the world, and especially in China and Europe. However, this is still too soon to talk of a recession, even though a slowdown in growth may be expected in 2019, with the Fed also reducing its GDP forecast for 2019 by 0.2%, and raising its unemployment forecast by 0.1%.
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Dr Nektarios Michail
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