That said, investors may still want to exercise caution this September, but for a different reason than seasonality: the Federal Reserve or the Fed watch! While the potential for a September Fed hike has been well telegraphed, a rate increase next month could still be disruptive given a slowdown in the global economy and the recent drop in U.S. inflation expectations.
Market Realist – The Federal Reserve had fixed the federal funds rate between 0% and 0.25% to combat the effects of the recession caused by the US financial crisis (XLF). You can see this in the above graph. Now that the economy is looking robust and firmly on the path to recovery, the Fed is considering policy normalization. This would be the Fed’s first rate hike in almost six years.
The graph above is the Fed’s dot plot. Each dot signifies each Federal Open Market Committee member’s opinion on the appropriate federal funds rate and the rate of policy tightening. The Fed looks poised for a rate hike later this year. The date for liftoff was anticipated for September’s FOMC meeting. However, given the recent upsurge in market volatility, the probability of a September liftoff has dimmed somewhat.
The graph above shows the recent stock market rout in the United States. Stocks fell globally on account of the recent currency devaluation in China and the possible effects of a Chinese slowdown. The plunge in global equity markets and an uptick in volatility were largely considered to mean a postponement in the September rate liftoff. Moreover, Atlanta Fed President Dennis Lockhart was quoted as saying, “It’s going to be very tricky between now and year end to read the underlying trends in inflation because of the complicated factors of the falling oil prices playing through to gasoline prices, falling commodity prices on a global basis possibly playing through to other goods at least that are in the core inflation numbers. A sizable proportion of the components of the inflation indices have been very soft recently” (Source: Reuters).
However, the recent revision to Q2 2015 GDP growth estimates showed that the economy is stronger than earlier anticipated. The US economy expanded at 3.7% in Q2 2015. The strengthening economy and the robust labor market could act as cues for the Fed to hike rates this fall.
A rate hike would affect both equities (VOO) and bond markets (BND). A rate hike accompanies falling Treasury prices (IEF)(TLT). Investors tend to avoid rate-sensitive segments of the market like utilities (XLU) and consumer staples (XLP) and instead seek refuge in cyclical sectors like technology (IYW) and healthcare (XLV), which tend to perform well even in a rising rate environment.