May 24, 2016
So what does this all mean for stocks?
Cheap Money Leaving the System
1-2 hikes this year would mean that the cheap money is leaving the system. The hallmark of the post-crisis economy has been easy money. The Fed wanted investors to borrow cheap money to invest in projects and companies, and some have gorged on those low rates. 2015 set a record for corporate bond issuance at over 1.04 trillion. With rates set to increase, and borrowing set to become more expensive, we could expect to see a decline in M&A activity as well as stock repurchases.
A decline in stock repurchases is a big deal. For the first quarter of 2016, retain investors have not meaningfully purchased stocks, sovereign wealth funds have been net sellers due to the low price of oil, and institutional buyers have been on the sidelines due to volatility which leaves corporate share repurchases as one of the only net buyers of stocks in the market. An event that reduces corporate share repurchases is a net negative for the stock market.
2. Fed Language
This is probably one of the more frustrating ways that a Fed rate hike can affect the markets. Depending on the language that the Fed uses in their next meeting, regardless of whether they raise rates, will have a large impact on how people view the rate market going forward. Their views on the rate market may mean that rates rise even without an actual rate hike.
If it appears that the Fed is intent on normalizing rates at a quicker pace than the market expects that would be a large negative for the stock market. In the very short term, it would a spate of M&A activity as well as a surge in corporate bond issuance as companies seek to front run higher rates.
For the past several years there has been a significant disconnect between the forward rate curve which is the market’s expectation of rates in the future and what the Federal Reserve has projected. A surprise to higher rates would therefore be unexpected by the bond market, and could lead bond market volatility– not a great environment for corporate bond issuance.
3. Strong Dollar
The United States would be the only economy in the world with a tightening monetary policy. In a world where the other large developed markets such as the EU and Japan are pursuing novel monetary policies on the leading edge of expansionary monetary policy, the United States would be alone in tightening. This could have the effect of a much stronger dollar.
Many countries especially in the developing world have debt denominated in dollars, so a stronger dollar makes their debt repayments far more expensive. Secondly, it could exacerbate the commodity downturn, since many commodities trade in relation to dollars. A continued depression in commodities would have the effect of lowering inflation both abroad and within the United States.
Most directly relevant to the stock market, a stronger dollar would harm companies that rely heavily on exports for profits. A stronger dollar means that their exports would be less competitive in the markets that they are trying to sell in, and would lead to downturn in both earnings and revenue.
Nobody knows for sure whether the Federal Reserve will hike or not this summer, but recent statements made by voting members make it seem increasingly likely that with the right data they would err on the side of a hike. There is also the possibility that the Fed would like to maintain a strongly apolitical stance and raise rates before the presidential election cycle really gets underway. Either way, a Fed hike would have a significant impact on the market, and likely result in a stock sell-off.