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The ‘Fed Effect’ – A Twist in the Tale

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In the Fed statement from the week before last, the central bank removed the word “patient” and set the stage for a normalization in interest rates later this year. Its recognition of the recent economic softness was interpreted as a dovish stance. Treasuries rallied on the announcement, with the yield on the 10-year Treasury dipping back below 2%, as equities swung from a loss to a 1% gain.

Fed effect - dot plot

Market Realist – The previous graph shows the Fed’s dot plot. It’s a chart that indicates each FOMC (Federal Open Market Committee) member’s opinion regarding the appropriate pace of tightening. Each dot represents a member.

The Fed reduced its median estimates for the federal funds rate from the December estimates of 1.125% to 0.625% for 2015. The median rates for 2016 have been lowered to 1.875%. The Fed acknowledged the weak economic indicators that are prevailing.

It dropped “patient” from its monetary policy statement. This could mean a normalization of rates later this year. Read The Fed’s ‘Patience’ Is Gone, but Will Things Change from Here? to understand the significance of this move.

The above chart shows the summary of economic projections. The projections were issued by the Fed after its March FOMC meeting. Recognizing the softness of economic data, the Fed slashed its GDP (gross domestic product) estimates from 2.6% to 3% in December to 2.3%–2.7% for 2015.

Investors largely ignored the removal of “patient” from the statement. Investors rejoiced at the cut in estimates. The “Fed effect” was clear. Positive investor sentiment buoyed US stocks (SPY)(IVV) to their first weekly gain in four weeks—for the week ending March 20, 2015.

The Fed’s QE (quantitative easing) and near zero interest rate policy has often been attributed as the reason behind volatility (VXX) remaining below the historical average in the last few years.

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However, here’s the twist in the tale. The “Fed effect” is now ironically adding to increased turbulence. Investors continue to speculate about the Fed’s next move. Although the Fed is treading with caution when it comes to hiking rates, a larger or faster-than-expected hike in the rate will likely destabilize the markets.

fed effect - rate hike causes fall in returns

A hike in rates usually causes an outflow from Treasury (TLT)(IEF) and bond (BND) markets. A rise in yields means a corresponding fall in prices. The equities market is affected. The rise in borrowing rates cramps business spending. In turn, this could affect corporate earnings.

The previous graph shows the impact of rising rates on each sector of the S&P 500. With the exception of materials, telecom, and technology sectors (QQQ), all of the other sectors tend to give negative returns in the six months after the first rate hike. Utilities (XLU) and staples (XLP) give negative returns even in the months preceding a rate hike. Historically, the healthcare (XLV) sector gave negative returns of -6% in the six months after the first hike.

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